Fed’s forward guidance is ’fatally wounded’, can Yellen undo the damage?

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The global trade and economic environment is stabilising, and the Fed must and will begin a gradual process of normalisation now, says Shaun Port (pictured), CIO of Nutmeg…

If the Fed hikes, it will be the first of many small hikes over the next two to three years. At the time of writing, a nearly 80 per cent probability is attached to a Fed move tomorrow. That’s as good as fully priced, and so a move should not rattle markets. Tightening is a sign of healing. Healing balance sheets and rising nominal anchors such as wage growth and core inflation are all positive for equity assets, and detrimental for assets with fixed income components.

If they don’t raise rates, markets will consider that the economic outlook has deteriorated more severely than the Fed thought even one month ago. This can only be a negative for risky assets.

In the markets, we see a complex picture involving systemic adjustments in emerging markets – and this allows the Bank of England a little breathing room. But as 2016 gets under way, we expect data and market performance to surprise on the upside."

Despite the hubbub about China's role in the world, the US is still the centre of gravity for global financial markets. What the Fed does this week is critical for bond yields everywhere. And it is critical for central bank credibility too; do central banks do what they say they are going to do? And it is this very question of credibility that will plague the Bank of England which continues to sit on its hands at near-zero interest rate policy. 

After the Fed lifts off and bond yields rise, the Bank of England will increasingly look embarrassingly behind the curve. That, together with our upbeat view on growth, is why we have positioned our clients' portfolios overweight equities and underweight fixed income assets."

Forward guidance' lies fatally wounded on the global financial market floor. Over the last few months, Governor Yellen has led a train of Federal System governors in guiding financial market expectations towards an interest rate “lift-off” at its December 15/16 meeting. Can the dovish Governor Yellen undo the damage already inflicted by her foreign central bank contemporaries?

Mark Carney, Governor of the Bank of England, shamelessly reneged on his 2013 forward guidance regarding a UK unemployment trigger for tighter monetary policy. He went on to whiplash markets during 2014/15 with his public musing over whether markets had priced sufficient probability for a rate rise.

During the autumn, Mario Draghi set up market expectations for a significant expansion of quantitative easing by the ECB in December. He didn’t deliver, causing the Euro to strengthen 4 per cent and stock and bond markets to sell off in December.

The Peoples Bank of China pledged support for the country’s stock market in early July, “actively assisting” public authorities to obtain “ample liquidity” to prop up the plummeting market. That forward guidance worked for just over a month – but markets subsequently fell 30 per cent further before finding a base.

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