ANZ: Bonds and stocks are being influenced by different factors, and that's a problem for the Federal Reserve

Photo by Chip Somodevilla/Getty Images

While others think markets have reverted to risk-on, risk-ff behaviour – simply bundling assets together as being “risky” or “safe havens” and trading swings in investor sentiment accordingly – analysts at ANZ research believe the recent price action has been more nuanced, suggesting global equity and bond markets are now diverging when it comes to the underlying drivers of market moves.

Here’s a snippet from the bank’s Tuesday morning note, explaining what’s been driving equity market movements of late.

Recent market behaviour has shown what looks to be Jekyll and Hyde traits. Equity markets are increasingly gravitating to a ‘good news is bad news’ view of the world, whereby positive data has seen markets retrace as expectations of Fed rate hikes are bought forward and the USD lifted. The dichotomy displayed is that this view is not permeating through to rates markets.

Essentially it’s good news when the economic data is weak, as it lessens the chance of US rate hikes in the period ahead. Conversely, strong data, such as last Friday’s US retail sales report, is often seen as bad news with equity markets often selling off as a consequence as it increases the likelihood of higher interest rates and less attractive equity market valuations.

Unlike stocks, ANZ suggests that bond markets are focused on the outlook for the global economy.

Even though the tone of recent US data has been reasonable, US Treasury yields remain low, and the odds of a rate hike remain marooned below 10% for June and around 50% by the end of the year. In rates markets, global considerations, including potential Brexit concerns and Chinese growth slowdown fears, look to be dominating local considerations.

The divergence has created a bind for the Federal Reserve when it comes to the outlook for US interest rates, creating a situation where the prospect of higher rates generates significant volatility leading the bank to push back the timing of further rate increases in order to stabilise financial markets.

That’s certainly been seen before. One only has to look at the so-called “taper tantrum” of October 2013 when stocks and bonds crumbled when then FOMC chair Ben Bernanke first mooted the idea of curtailing asset purchases as part of the Fed’s quantitative easing program.

It’s an adverse feedback loop, created by the Fed itself thanks to incredibly accommodative monetary policy driving asset prices to current levels.

They take away the fuel that’s been driving asset markets and prices subsequently fall away, diminishing positive wealth effects and leading to expectations for slower economic growth as a consequence.

So how can the Fed break this feedback loop?

ANZ has a simple solution, although it would involve a balancing act for the Fed.

“Nowadays the US economy is firmer under the bonnet, the labour market has strengthened, and US inflation looks to be picking up,” says the bank. “This suggests the Fed should likely contemplate signalling that rate hikes are on their way, but in such a fashion so as to deliver minor market disruption.”

It sounds simple but isn’t, with poorly worded statements having the potential to send financial markets into a spin in an instant.

As has been the case over the past few years, it’s a difficult task that faces FOMC members. It’s why they get paid the big bucks, at least after they leave their official postings.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.