FED PULLS A JEDI MIND TRICK ON THE BOND MARKET / THE FINANCIAL TIMES COMMENT & ANALYSIS

The Short View

February 26, 2015 7:40 pm

Fed pulls a Jedi mind trick on the bond market

James Mackintosh

If the Fed proves willing to ignore an oil-driven decline in prices, rates could rise by June

Seen from Europe, the Federal Reserve appears to have carried out a Jedi mind trick on the bond market.

On Thursday, the US reported that it fell into deflation last month, with prices dropping 0.1 per cent year-on-year. Janet Yellen, Fed chair, had just told Congress that “these are not the prices you’re looking for” and the bond market reacted with higher yields. (Ms Yellen actually talked of “the transitory effects of lower energy prices”, but she doesn’t have George Lucas to help with her script.)

 

In Europe, central banks took drastic action and bond yields plummeted as the eurozone fell into deflation, even though prices calculated on the same basis — excluding housing costs — fell faster in the US in January.

 

If the Fed proves willing to ignore an oil-driven decline in prices, rates could rise as soon as June. Futures markets currently price a four in 10 chance of two rises by December. How worried should shareholders be?

History suggests any hit will be temporary. In six of 11 US rate cycles since 1960, shares were down three months after the first hike. But Birinyi Associates points out that, after six months, shares were up in all but three cases, and the average gain was 4.3 per cent.

The explanation is simple enough: rates usually go up when optimism about the economy, and so inflation, is rising. The same optimism tends to push up stocks.

This logic also explains the tight link between bond yields and the outperformance of the “cyclical” shares most exposed to economic growth (see chart).

After six years of zero rates, this time could be different. After all, one of the best bull markets accompanied a pretty dismal period for the US economy. If wage pressure shifts cash from shareholders to employees, a stronger dollar hurts companies with international exposure and higher rates hit those that took advantage of easy money to gear up, it could be time for Main St to benefit at the expense of Wall Street.

Really bad news would rely on Ms Yellen transforming from a cuddly Ewok into Darth Vader.

If the Fed raised rates because of worries about over-exuberant financial markets, not inflation, it would demonstrate the true power of the Dark Side.