Don’t fight the Fed, even when they are virtual

The chair of the Federal Reserve announced a major policy shift for the Federal Reserve in his opening speech at the virtual central bankers symposium on Thursday. The Fed expects to allow inflation to run above its 2% target to make up for periods when inflation has fallen below the target rate when the economy has been weak. This is essentially an abandonment of its duel mandate to manage employment and price stability, which has been in place since 1977. 

What the Fed’s policy shift means for markets 

In theory, this shift from the Fed suggests that interest rate policy will remain lose for the foreseeable future, even if the labour market tightens and if inflation rises above 2% in the coming months. The reason for the shift in policy is to make up for the drop in prices at the peak of the coronavirus pandemic. In Q2 the US consumer expenditure prices index fell to -1.8%, well below target and was a reflection of the deep recession that the US and global economies were plunged into when the world went into lockdown in March. 

We will discuss the market impact in more detail shortly, however, this move from the Fed is important for the future direction of risk in two ways: 1, it shows the Fed’s commitment to supporting the economic recovery at almost any cost, even allowing inflation to rise above target. 2, it suggests that low interest rates are here to stay, which is one of the major drivers of the stock market recovery in recent months. Now that shorter term yields are falling, there could be more room for stocks to rally, as equity returns look more attractive compared to the returns in the bond market. 

The bond market signals good news  

The immediate impact of the statement was felt in the US Treasury market, where the yield curve steepened sharply. This happens when longer dated bond yields rise above short dated bond yields. The difference between 5-year and 30-year Treasury yields is now 120 basis points, and 10-year US Treasury yields are at their highest level since June. A steepening yield curve is usually the sign of a healthy economy – interest rates will rise in the future, as the economy picks up. However, this time the steepening yield curve is largely due to the Fed’s intervention. The economic data so far this week has been mixed, there was good news for home sales, but there was confirmation of a 31.7% annualised decline in GDP in the second quarter, and there are signs that the second wave of covid infections is starting to weigh on the labour market, US initial jobless claims rose above the 1mn mark last week. At this stage of the third quarter, the US economy seems to be running on two different tracks – consumer spending and manufacturing have out-performed in June, July and into August, while the labour market is more jittery. 

Testing deal a cause for stock market cheer 

We will have to see in the coming weeks if the Fed policy shift will boost the labour market, however, what could have a bigger impact on the labour market is the other news on Thursday that the US Federal Government is set to sign a $750mn deal to buy Abbot Laboratories fast-track coronavirus test, after they were authorised by the Food and Drug Administration. Rapid testing could help to avoid future lockdowns, keep economies open and keep people at work if there are future waves of covid infections. Abbot Laboratories was one of the big winners on the S&P 500  on Thursday after the news was released, and it rose 7.8%. Its shares are at an all-time high, unsurprisingly, and we could see further upside, particularly if there is a delay to a vaccine, and if the tests prove an effective way to keep the US economy up and running throughout the pandemic. Obviously, any signs that a vaccine is imminent could weigh on their share price. 

Are banks set to play catch up with tech? 

Back to the Fed’s policy shift, this could be the news that allows banks to play catch up with tech, since a steepening yield curve helps banks with a large retail presence, such as Bank of America and JP Morgan, earn more on their lending products. JP Morgan Chase was higher on the back of Powell’s speech; however, banks share prices remain well off their YTD highs, and their recovery in recent months has been tepid, with financials being one of the worst performing sectors in the S&P 500 as the prospect of a slower economic recovery and a wave of bad loans has kept the lid financial sector stock prices in recent months. We have mentioned in previous notes the stark difference in valuations between some of the tech giants like Amazon, that has a P/E ratio of 126, vs. the banks such as JP Morgan that has a P/E ratio of 13.55. Looking to the future, surely the confirmation of the Fed’s policy shift should encourage bargain hunters to snap up the banks? If so, this would be good news for the US stock market rally as it would make it less reliant on tech and more broad-based. It could also help lift financial shares in Europe, which could be good news for the FTSE 100. 

Elsewhere, the news about the rapid response covid test was good news for US airlines and cruise operators, as timely and effective ways to manage infection rates are crucial for the battered travel industry. We believe that stock markets could show strength as we end the week, and this optimism could spread to Europe. European stocks have lagged behind the US this week; however, they could try and claw back some losses on Friday. 

GBP: one to watch  

The central bankers symposium continues on Friday, the highlight will be Bank of England governor Andrew Bailey’s speech at 1305 GMT. He is expected to shed light on whether the BOE will embark on negative interest rates in the near future. While we don’t think that he will suggest that this policy is imminent, we expect him to reiterate that UK interest rates will stay low for a long period of time. However, if he fails to point to negative interest rates, then we could see the pound rally, GBP/USD is hovering just below the $1.32 level and may break through this level if Andrew Bailey is less dovish than expected. EUR/GBP is also at its lowest level for a month as the pound strengthens on a broad basis this week. A break below 0.8950 opens the way to 0.8870, the low from the first week in June.