Given recent developments in the world economy, including in the US, the reference to ‘uncertainty’ in the title of Janet Yellen’s recent remarks at the Economic Club of New York was most appropriate. Confronted with uncertainty, households and corporates will become more cautious: spending and investment decisions may be postponed until a clearer picture emerges. For central banks, factoring in the role of uncertainty is particularly complex when interest rates are very low. A policy mistake, i.e. a tightening which subsequently turns out to be unwarranted, can cause a drop in economic activity, which would be hard to counter considering that rates are still close to the zero lower bound. This calls for gradualism, as so eloquently explained by Janet Yellen in New York, which implies proceeding slowly when hiking rates. The market liked the story. With the help of the central bank, increased uncertainty was a signal to take more risk…

This is the umpteenth example of how closely expectations of Fed policy and the equity market are linked. The following chart shows the evolution since February 2015 of the S&P500 stock market index and the probability that on the occasion of its meeting on 14 and 15 June 2016[1] the Fed funds rate would be in the 0.50-0.75% range (implying two hikes when considered before the December 2015 and one additional hike after the December 2015 tightening).

graphique01.04.2016

Seven episodes illustrate the mutual influence between Wall Street in New York and Constitution Avenue in Washington DC:

  1. Positive correlation between equities and rate hike likelihood
  2. Equities drop following the surprise devaluation of the Chinese yuan. Rate expectations hardly move
  3. Rate hike expectations have declined fuelling a ‘risk on’ attitude: equities rally. In a second stage and in conjunction with the data flow, rate hike expectations increase, implying a positive correlation with the stock market
  4. The FOMC decides to raise the Fed funds rate and expectations of another hike increase. Equities are very volatile
  5. The very poor start of the year in equity markets (uncertainty about China and ever lower oil prices) makes another rate hike by June 2016 less likely
  6. Stocks rally from oversold territory on the back of better data and soothing words from the Chinese central bank president. Fed rate hike expectations increase again, implying a positive correlation with equities
  7. Dovish comments by the FOMC and Janet Yellen cause a decline of rate hike expectations but Wall Street likes the news: there is less of a need to be concerned about policy tightening. Bad news is good news again and the correlation between equities and tightening expectations has changed sign, turning negative.

All in all it has been a tumultuous ride over the past year with changes in causality (from expectations about Fed policy to stocks and the other way around) and changes in the sign of the correlation. One would almost fail to notice how volatile the market has been but also that the evolution has been quite simply … sideways.

[1] This is based on the WIRP screen on Bloomberg.

 

William De Vijlder

Group Chief Economist, BNP Paribas

31 March 2016