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The Bond Column

The Fed and Market Panic
Updated: 2015-08-24, 08:56:40 ET
Analyst: David Kelland

If you were vacationing in the Arctic Circle this week, youshould know that it was a bad one for equity markets around the world. TheS&P 500 finally broke out of its 6.9% range for 2015, and did so somewhatconvincingly. What does this mean for Treasuries?

While the FOMC members rarely reference equity markets inpublic communications so as not to be seen as curmudgeons and to not risk theircredibility on the vicissitudes of market psychology, there can be little doubtthat the Fed does pay attention. One of the stated goals of quantitative easingwas asset-price inflation, which was supposed to (and probably did) havepositive wealth effects. When people feel richer because stock and home priceshave risen, they spend more.

More recently, however, the Fed has seemed to move in thedirection of concern about equity market valuations, with Fed Chair Yellenspecifically referencing high biotech and media group valuations. It's evenpossible that financial stability goals (not blowing asset-price bubbles) havebeen part of the unstated reason for moving towards policy normalization. Afterall, with WTI crude set to drop below $40/barrel and wage growth restrained,what would the hurry be to raise rates, especially considering that the Fed hasundershot its 2% goal for the PCE Price Index since mid-2012.

If emerging markets continue to decelerate, commodity pricesremain low, equities decline, and the Fed continues to undershoot its inflationtarget, why the need to hike? The justification that it would be good to have somemonetary ammunition to fire at the next economic slowdown makes no sense. Raisenow so you can cut later? That only passes the laugh test if you believe thatthe power of interest rate cuts is mostly psychological.

Even if the Fed chooses to hike rates in September, the financialsqualls that are forming in Asia could lead to a much lower and slower path forrate hikes than the 5-year yield (1.44%) is currently predicting. Economicexpansions since 1857 have tended to last 42 months, according to AvondaleAsset Management. We are now in our 6th year of expansion, so arough patch would be in order.

- David Kelland,