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The Fed spells it out – ignore political risk at your peril

Posted By Gavin Madson On In Economy | No Comments

Political risk will continue to come to the fore in markets this week, with “midnight Monday” (the end of September) looming. In this recent bull run, some markets have continued to ignore the underling risks to their peril. Here we look at the (very) short-term risk and what the Fed is telling us.

Recently, the Federal Open Markets Committee of the US Federal Reserve Board (FOMC) highlighted the prospect of political risk as well as its continued dampening of growth expectations, which are being priced into markets. Investors should take note.

In many ways, the decision by the FOMC to delay tapering took a lot of courage. Generally, the FOMC and their expectations remain in the middle ground between a financial market that remains wildly optimistic, in terms of growth expectations, and economic reality, which just keeps failing to live up to these expectations.

The FOMC refrained from tapering for three main reasons:

  1. Growth and unemployment are “yet to provide sufficient confirmation” that the baseline assumptions about growth, unemployment, and inflation will be hit.
  2. The “rapid tightening of fiscal conditions” threatens the baseline forecasts, which means that higher longer-term interest rates are crimping growth in the housing market, among other markets.
  3. The debt ceiling debate may impact perceptions about baseline forecasts as well.

While the market wants certainty on the issue of tapering, the fact is that there is no certainty. Economic recovery remains fragile, and the return to “normality” is far from assured. In terms of future expectations, we expect more of the same; current growth estimates will fall yet again in December, and current expectations of tightening should be moderated again and pushed further into 2016 from 2015.

Political risk to the fore

In the press conference accompanying the continued QE path, Chairman Bernanke noted two hurdles arising from domestic political risk:

  1. The government appropriations approval that needs to be approved before midnight on September 30.
  2. There is the debt ceiling issue that needs to be approved by mid to late October.

The main issue remains what the Republicans refer to as “ObamaCare”, where Republicans do not want the reform to be implemented, nor funded by the US government, or both. This leads to either a shut down, or threat of a shut down, of the US government. The same threat in 2011 had a significant effect on the US equity market and markets will increasingly prepare (i.e. sell off) in preparation for a similar threat heading into next week. The threat of the shut down impacts the markets perceptions of growth, and it is for this reason that the FOMC mentioned it. The FOMC officials rarely waste time by mentioning irrelevant facts.

Summers out, Yellen to the fore

The other big news from the Fed has been the withdrawal of Larry Summers from the running for next Federal Reserve Chairman, which has pushed Janet Yellen to the fore as the most likely candidate. This is of interest as Yellen has a far more pessimistic view of the US recovery than Summers. Summers’ withdrawal saw Australian 10-year bond prices jump (lower yields).

Yellen has consistently pointed to the lower housing contribution to the current ‘recovery’ and the stubbornly high unemployment rates as a concern.

Conclusion

The Fed believes growth is slower than the markets are factoring in, and political risk remains present, and undervalued.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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