Andrew Miller: Volatility is testing investors' patience

Yet another bout of volatility is testing investors’ patience. This one, however, likely marks the beginning of a return to normality, not a divergence from it

Yet another bout of volatility is testing investors’ patience. This one, however, likely marks the beginning of a return to normality, not a divergence from it.

When the dust has settled, the Fed’s decision to nudge interest rate expectations upwards may be seen as a signal that they, like us, think the US economy is increasingly able to stand on its own two feet. It could be a bumpy ride, but this prospect will eventually prove better for stocks than bonds.

Fed up? We have to deal with it – and it needn’t be bad news.

We noted recently how the uncertainties facing investors seemed to be resolving into a single question, namely: is recovery all just the result of central bank support, or is there some substance behind the stock market’s rally?

That question is being addressed a little sooner than we’d though as the Federal Reserve (Fed) has pushed interest rate expectations up, but our conclusion remains the same: normalising monetary conditions will eventually prove more of a strategic headwind to bonds than stocks.

The Fed’s suggestion that quantitative easing (QE) “tapering” will likely begin in the months ahead – our economists think September is the most likely month for bond purchases to be trimmed – has triggered sell-offs in most asset classes. In fact, neither the Fed’s comments, nor the markets’ response, are a big surprise.

The medium-term prospects for US economic growth has brightened as the US consumer’s resilience has been underscored by recent employment and balance sheet data, and as the tumbling budget deficit has reduced the need for a big, medium-term fiscal tightening. Market nerves are understandable because many commentators are arguing QE and low interest rates are all that stands between us and a resumed full-blown crisis.

The Fed’s comments were focused on QE, but were always going to have an impact on interest rates. Long-term rates are affected directly: QE has helped keep bond prices high and yields low. Short-term interest rates are also affected, despite the Fed’s own guidance suggesting that they see rates staying put through 2014.

The rise in long-term rates has been so pronounced that it has pulled the front end of the yield and swap curve higher with it, and forward interest rates for late 2014 have risen sharply, to the extent that they are more or less pricing-in a policy move.

As noted, worried economists will argue that higher rates will de-rail the US and global economy. We’re optimistic they won’t. Usually, the correlation between interest rates and growth is positive: cause-and-effect runs from the economy to interest rates, not vice versa. The current situation is admittedly complicated by the range of emergency measures that have to be unwound (“unconventional” QE alongside “conventional” low interest rates). It is also complicated by the extent of loosening that has occurred (the Fed has bought $2trillion of bonds already, and the Fed funds policy rate at 0-0.25% is at its lowest in our working lifetimes).

But this argues for a gradual, well-signalled normalisation, not a dramatic one. The Fed, after all, is not planning to stop buying bonds overnight – and the Bank of England, the Bank of Japan and the European Central Bank have are not signalled any normalisation as yet. Admittedly, the Bank of England stopped buying UK government bonds a year or so back, but the new governor’s arrival may if anything usher in a slightly more lenient regime. In Japan, the central bank’s latest experiment with QE has only just got going.

The ECB has not been trying to “print” money, but has little reason yet to signal any hawkish intent.

:: Andrew Miller is a director of Barclays Wealth and Investment Management in Newcastle


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