Equities do better with Fed pledge on rates

Mar 24 2010 by Andrew Miller, The Journal

EQUITIES and other "risky" assets have performed rather better in recent weeks, helped by the repeated promise from the US Federal Reserve to keep interest rates at "exceptionally low levels" for an "extended period".

The Fed knows consumer and business spending are picking up, but reckons that the economy may still be weak, with employers still reluctant to create jobs, thus leaving the jobs market in the doldrums. The Fed therefore prefers to adopt what could be called a “wait and see” approach on monetary policy.

However, while the Fed’s behaviour is important, it is not the only thing that the markets have to consider. Indeed, if we examine what the markets themselves think about the economic outlook, the evidence here appears rather contradictory at first. Bond yields have not risen by as much as might be expected, and some commentators have taken this as proof that the bond markets are taking a more pessimistic view about economic recovery than the equity markets.

But the US Treasury market rallied alongside stocks when the Fed made its promise: this suggests that it is the reality of low short-term interest rates, rather than a bearish view of the US economy, that is keeping bond yields down.

Arguably it is the steepness of the bond yield curve, rather than the absolute level of yields, that is a better indicator of the state of the economic cycle. The yield curve measures the relationship between bond maturities and bond yields. Normally the curve slopes upwards: in other words, investors in longer-maturity bonds are compensated with higher yields.

The current upward slope of the yield curve is very steep, something that usually precedes a recovery. In contrast, a downward curve normally indicates investors think interest rates will fall, and is often seen before the onset of recessions.

In fact, the difference between the yields on two and ten-year bonds is probably now as high as it has ever been. At some point this difference will diminish and the yield curve will flatten.

This seems unlikely to happen much in the next year, with central banks likely to remain reluctant to tighten monetary policy too abruptly given the billions of dollars that have been spent on avoiding a re-run of the 1930s “Great Depression”. But when this flattening of the yield curve occurs, it could be dramatic, with detrimental effects not just for bonds but also stocks.

However, it could take the form of what bond traders call a “bear flattening”, where the yields on longer-dated bonds don’t fall, but rise by less than short-term yields.

Monetary tightening and the resultant sharp rise in bond yields has the potential to test the equities rally more severely than of late. But in our view the business cycle, valuations and some revival in investors’ risk appetite should offer support to stocks at this point.

One interesting fact is that the amount of cash sheltering in US money market mutual funds is poised to dip below $3 trillion for the first time since 2007 – but this is still far from small beer, being equivalent to more than a quarter of the S&P 500’s entire market capitalisation. Some – but not all – of this cash pile is likely to be put to work in “riskier” assets as investors seek higher returns.

Andrew Miller is head of Barclays Wealth in Newcastle