US stocks were treading water for most of last night’s session, but collapsed late after Yellen signalled the Fed may soon raise interest rates.
The actual Fed statement contained no major surprises. The central bank lopped another US$10 billion off its monthly bond purchases, to US$55 billion, and stimulus is still on track to be completed by the end of the year,
Raising interest rates
The shocker for investors, however, wasn’t the statement itself but Janet Yellen’s press conference at the conclusion of the Fed meeting.
Specifically, it was her response to a journalist’s question on how long until the Fed began raising interest rates.
Yellen replied, “…This is the kind of term it’s hard to define, but, you know, it probably means something on the order of around six months (after the end of stimulus tapering) or that type of thing.”
Her comments had a dramatic and immediate impact on markets. The Dow sank more than 200 points last night before recovering slightly towards the end of the session.
The following chart shows the severity of the move on US markets.
It’s not just US equity markets that bore the brunt of her comments. The losses have spread to Asian markets in today’s session, whilst gold and the Aussie dollar have also taken a dive, illustrated below.
The widespread market reaction to Yellen’s statement is a slight cause for concern, but as we mention below, the current volatility is likely to have a limited shelf life.
The Fed had stated previously it was likely to maintain interest rates at zero well past the time that the US unemployment rate declines below 6.5%, especially if projected inflation continues to run below its 2% longer-run goal.
March’s statement effectively dropped this threshold, with Yellen saying the Fed will instead look at a wider range of factors in determining the next move on rates.
Although the economic criteria might have changed, the hawkish tone of the comments shouldn’t really be a surprise to investors.
The US jobless rate was 6.7% in February and is widely expected to head lower over the following months as economic growth improves.
Even Janet Yellen said the labour market had improved a little more than she had expected. FOMC members anticipate an unemployment rate of between 6.1% and 6.3% by the end of 2014.
Inflation is still well below the Fed’s threshold, with core inflation running at a 1.1% annual pace over the year to January 2014.
Again, stronger US growth is likely to put upward pressure on prices and the Fed may act on rates even if inflation technically remains below the 2% threshold.
Assuming stimulus tapering wraps up by the end of this year, Yellen implied the first rate hike may occur around June-July 2015 – a good 15 months from now.
In fact, the bond market has largely priced in higher interest rates. The rising trend in the US five-year Treasury Bond Yield not only reflects this, but also expectations of a healthier US economy.
What it means
What spooked markets today was the first mention of the six month timeframe for raising interest rates. It is worth noting that any rate hike by the Fed will be in response to a stronger economy.
Even then, the rate hikes are likely to be gradual and will start off a very low base – the Fed Funds Rate is currently below 0.25%. It will be some time well after 2015 that US interest rates return to normal levels in the vicinity of 4%.
What does this mean for markets? There is now an apparent conflict between Yellen’s comments and the long-held belief US interest rates will remain at zero for a considerable time after the end of QE.
Markets may be in for some short-term volatility, particularly if there is another flare up of tensions in Ukraine and data out of China continues to underwhelm.
However, by outlining a more definitive timetable of when it plans to raise interest rates, the Fed has introduced a greater level of certainty.
This should be seen as a longer-term positive for markets.