What follows is entirely fictitious and does not constitute a forecast
It had all looked very promising. After years of abnormally slow recovery from the Great Recession of 2008-2009, after years of ultra-loose and unconventional monetary policies, after deftly circumventing the fiscal cliff and after digesting the long-term plan to bring the budget deficit under control, the US economy finally appeared to be back on the right track in 2015. GDP growth was structurally above 2% and, more importantly, unemployment was on a clear downward trend, even though the active population was expanding because more people decided to seek a job. Nevertheless, some clouds appeared on the horizon. The fall in unemployment was bringing the economy ever-closer to the 6.5% that the Federal Reserve had set in December 2012 as the level at which it would adjust its ‘forward rate guidance’. With that ‘forward rate guidance’ the Federal Open Market Committee wanted to indicate when an adjustment to the federal funds rate was likely. Prior to December 2012, this ‘guidance’ was given on the basis of a date. For instance, a statement would be issued, saying “we will not raise interest rates before mid-2015”. In December 2012, the decision was taken to link the ‘guidance’ to hard data. It was thought that this would enhance transparency and be conducive to a more gradual adjustment of bond prices. With hindsight, the difference between date-based and data-based guidance proved to be very considerable indeed. As the unemployment rate steadily diminished from 6.9% in early 2015 to 6.8% and ultimately 6.6%, bond investors became more and more nervous. This was reflected in the volatility of long-term interest rates, but also in the bond market’s reaction to employment data surprises (i.e. data that deviated from the consensus forecast). Formerly, it took a fairly big positive surprise (i.e. a significantly lower-than-expected unemployment rate) to prompt a substantial rise in long-term interest rates. Now, however, the closer we came to the 6.5%, the more sensitive long-term interest rates became to surprises in economic data. The publication of every key figure thus became an anxious nail-biting exercise.
When the employment statistics were to be published in early August 2015, nerves soared to fever pitch in the preceding days. No wonder: the consensus forecast was that unemployment would fall from 6.6% to 6.5%, thus possibly triggering a Fed policy adjustment. The floodgates truly opened when it turned out that the unemployment rate had actually fallen from 6.6% to 6.4%, signalling to bond investors that a rise in the policy rate was imminent. Within minutes, long-term interest rates jumped 75 basis points and, predictably, Wall Street opened sharply lower. In the ensuing days, the markets remained jittery as investors sought in vain for something tangible to hold on to. In the end, some Fed governors attempted to provide clarity about the future policy focus. Sure, unemployment had sunk below the threshold set in December 2012, but that threshold had never been intended to automatically trigger a sharp interest rate hike. Unfortunately, this statement created more, rather than less, confusion: 6.4% unemployment meant that the distance to the NAIRU (the unemployment rate at which inflation does not accelerate) had shrunk considerably, while Ben Bernanke had stressed at the launch of the new communication policy in December 2012 that monetary policy had a strongly delayed effect, meaning that you needed to hit the brakes well in advance. The emphasis that was now placed on the fact that the sharp fall in unemployment would not necessarily lead to immediate interest rate hikes created doubts about the Fed’s determination to defend its inflation target. The result: higher inflation expectations, a weaker dollar and yet another spike in long-term rates. More and more investors started to reduce their bond holdings, if only to avoid further losses in their portfolios (the extremely low long-term interest rates made bond prices extraordinarily sensitive to rising long-term interest rates). Equities, incidentally, were also hit by fears that rising bond yields would deal a severe blow to the economy.
In the end, calm was restored when the Fed decided at its next meeting to raise interest rates by 25 basis points, adding that in view of the economic data no further policy tightening was to be expected any time soon.
William De Vijlder
Chief Investment Officer, Strategy and Partners
BNP Paribas Investment Partners
