The Federal Reserve about to be tested

Runaway U.S. equity markets should bring the U.S. Federal Reserve and its new chairman Jerome Powell into the picture earlier than previously thought. A rate increase at the 30-31 January meeting is increasingly possible and four, not three increases in 2018 more probable as the U.S. 2-year bond yield pushes through 2.0%. The two-year risk-free rate is comfortably above the 1.8% dividend yield of the S&P 500. A slumping US$ provides plenty of room for the Federal Open Market Committee (FOMC) to tighten monetary policy. Inaction could be at Powell's peril.

The words 'irrational exuberance' surely must be being whispered on Wall St and in the hallways of the U.S. Federal Reserve. The regulators should be issuing speeding infringement notices and cautioning excessive speed has serious consequences. Despite the Dow Jones Industrial Average (DJIA) not being the global benchmark of U.S. equity markets, the speed of the 1,000-point increase from 25,000 to 26,000, a mere seven days, was the fastest 1,000-point gain in the 120-year history of the index. The rapid rise of the S&P 500 and Nasdaq Composite is also breaking long-standing speed records.

In his latest letter, Jeremy Grantham alluded to the very real possibility of a melt-up in US markets with 3,400 to 3,700 on the S&P 500 not out of the question before a crash. For the last six months markets "have been showing modest acceleration, the base camp, perhaps, for a final possible assault on the peak." Grantham rates a "melt-up or end- phase of a bubble within the next 6 months to 2 years is likely, i.e., over 50%." And "if there is a melt-up, then the odds of a subsequent bubble break or melt-down are very, very high, i.e., over 90%." The degree of melt-down after a melt-up "is likely to be a decline of some 50%."

Global bond yields have surged over the past three months and there seems little disagreement the 35-year bond bull market has reached the capitulation stage, after a brave fight in 2017. While yields have increased across the board, the impetus has been at the short end with the spread between the short and long end narrowing and the yield curve continues to flatten - see Exhibit 1. The bond market is suggesting to investors that the global recovery in economic growth will be relatively short lived and inflation will not be of meaningful concern going forward. Hence the flattening yield curve, with the US curve leading the way.

Exhibit 1: Global bond yield spread

Source: Morningstar

As the US Federal Reserve moves to normalise its balance sheet, both the bond market, and to a lesser extent the equity market, are closely watching the purchasing of US treasuries by the People's Bank of China and the Bank of Japan. Both central banks hold almost all their foreign exchange reserves in US treasuries. The sheer enormity of the normalisation process, which requires the sale of treasuries and other securities purchased over the years of quantitative easing, will require buyers. The normalisation process will clash with the necessity for the US government to issue bonds to finance recent tax cuts and infrastructure spending.

A recent Bloomberg report suggesting officials in Beijing have recommended the slowing or stopping purchases of US treasuries saw global yields jump. Quaintly, officials suggested the report was "fake news", clearly in a dig at the US President.

As the Australian equity market continues to lag the U.S. and other northern hemisphere markets, so also the increases in bond yields, which reflect mostly lower growth expectations. While the S&P 500 has put on 4.8% and the Nasdaq Composite 5.7% in the new year to 17 January, the S&P/ASX 200 is down by 0.8%.

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Peter Warnes is Morningstar's head of equities research. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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