Posted by: Deepa Vasudevan on Sat, Oct 11th, 2014
The Rate Liftoff: Why Markets Don't Like it
Sometimes markets like uncertainty, sometimes they don’t. It depends on the uncertainty in question, and how it impacts market valuations. Consider, for example, the US Federal Reserve’s decision to end its Quantitative Easing program by October 2014. That part is certain, and has already been factored into market values. But once QE ends, the Fed is expected to raise policy rates (which have been close to zero since the 2008 crisis)- an event that has come to be known as the “liftoff”. Everyone knows that a rate liftoff is imminent, but no one knows when it will happen. That uncertainty makes investors nervous: any hint of a rate hike leads to panic selling.
The reason is that QE has enabled the Fed to pump cheap money into the economy. As yields on US debt fell, investors sought higher returns by investing in US equity, as well as in risky emerging market stocks. But the end of easy money will push up US rates, and divert a significant part of global flows back towards US assets. It is not just emerging markets that will suffer from such a re-allocation; institutions that have been generating tidy profits from investing in them will also bleed when the liftoff is fully in place.
What will trigger off expectations of a liftoff? To understand that, we need to understand that the US Fed operates with a dual mandate of achieving maximum employment and maintaining price stability. Operationally, this translates into an unemployment rate of about 6%, and an inflation target of 2%. Historically, when the unemployment rate falls below 6%, labour markets become tight. Workers are able to negotiate higher wages. Rising wages push up inflation. At this stage, it is expected, interest rates will be raised. Last week, when new data showed that September unemployment had dropped to 5.9%, it seemed that the first step in the liftoff process was falling into place. Key market indices fell across the world. Volatility indicators shot up.
But on October 8, 2014, the release of the minutes of the Sept. 16-17 Federal Open Market Committee meeting completely overturned market sentiment (available at (http://www.federalreserve.gov/newsevents/press/monetary/20141008a.htm). The report indicated that a rate hike was not bound to a set calendar date; rather, it would depend on several factors that could impact on growth. Fed officials concluded that employment had not picked up sufficiently, because labour force participation was poor and wage pressures were low. Low commodity prices were likely to keep inflation down. Emerging economies, notably China, which is a major trading partner of the US, were slowing down. The strengthening US dollar, weakening Euro economies, and geo-political tensions in Ukraine and the Middle East could bring down growth. In short, macro economic conditions were fragile, and the US remained vulnerable to slipping back into a recession. The key takeaway: the Fed would not increase interest rates yet, not for a few more months.
What has changed? Markets are no closer to guessing when the rate cycle will turn. Yet the continuing uncertainty was actually welcomed: the S&P 500 rose by 17% in a single day, the Dow Jones index jumped by 16%. The reason: the certainty of a few more months of easy money outweighed the uncertainty of an actual rate hike!
There are key lessons in this story for India, despite the fact that the US economy is structurally different. The US fears deflation, and India is battling persistent inflation. The US is approaching full employment, but India has a million young people looking for skills, education and jobs at the end of it. However, a common factor is the ability of both central banks to patiently wait for data that proves, without any doubt, that there is sustained progress towards its goals. The RBI is determined to hold rates until inflation and inflationary expectations are under control. The US Fed is set to hold rates until the labour market improves, and inflation inches closer to the target level. A hasty move made without careful assessment can backfire and force Central Banks to retrace their steps. It is easier for the Fed to accommodate zero rates for some more time rather than to increase rates now and be forced to reduce them again if its goals are not met. Similarly, it would be foolish for the RBI to drop rates now and then quickly increase them if inflation was to go up. Patience is the quality stressed by the US Fed. Perhaps it should be adopted by the many market watchers in India who endlessly argue for a quick reversal of interest rates.
Amol Chitale on Mon, Oct 13th, 2014 5:18:11 pm
A really good article. I now understand (a little bit) why the markets are so keen on the Fed's move.