Jerome Powell’s comments will have left markets disappointed with the lack of hints at what may be to come, despite taper predictions from the fringes.
Financial markets were eagerly awaiting the speech of the Fed’s Chair Powell last week as they continue to look for hints on when the Fed will start with tapering its asset purchases.
In the past few weeks, several other Fed board members commented in their speeches that the time has come to start tapering, so the question was whether Powell would give his approval for a taper announcement in the September meeting of the Fed.
Before we go to Powell’s speech, we should remind ourselves the extraordinary nature of current policy settings of the main central banks.
Combined, they are still purchasing about $800m (£581m) of bonds each day, which is still sufficient to keep interest rates at historically low levels.
Countries such as Italy and Spain can finance their government debt at around zero yield, refinance their government debt at around zero yields and even Greece must pay less than 1% to issue a 10-year bond.
The financing needs of the US Treasury have exploded due to the soaring budget deficit, but the average yield on its new bonds still does not exceed 1.5%.
If Janet Yellen, as the secretary of finance, would choose to issue the new US treasury debt through inflation-linked bonds, she would actually get paid by investors for her efforts, as the real yield on these bonds is now hovering around minus 1%.
With these numbers in mind, let’s look at Powell’s message.
Of course, he started with a description on the enormous impact of the coronavirus crisis on the US economy and the subsequent strong recovery. He also acknowledged that the labour market has recovered significantly and that more progress is to be expected.
As you would expect from a central banker, he spent most time on the topic of inflation and the main reasons why the Fed thinks that the current upward move of inflation is mostly a temporary phenomenon.
It is clearly still the Fed’s expectation that inflation measures will move down towards the target of 2% relatively soon.
At the same time, Powell did provide a strong warning that the Fed will not hesitate to adjust its policies if inflation turns out to be stickier.
But overall, there was no clear comment from Powell in his speech to suggest that a tapering announcement in September is a “done deal”.
The markets responded enthusiastically to the speech, with equities rising to a new high and interest rate markets also ending the week on a positive tone. One can imagine such a response: every extension of such purchase programmes is met with cheers from financial markets as these provide the extra liquidity and thus fuel for continued rallies.
We do note however that at some point central banks will start to withdraw these programs, which will result in a repricing of both interest rate markets and risk assets. We also see risks that the benign inflation view of the Fed will be challenged in the coming quarters, as producers are keen and able to push their increased cost levels to the consumer.
As a result, we do think that interest rates are due for a significant bounce in the coming quarters, which at some point might also hurt the positive sentiment in risk assets.
Hendrik Tuch is head of fixed income NL at Aegon Asset Management. The views expressed above are his own and should not be taken as investment advice.