"Phantom" Fed rate hike shows fragility of global financial sector
The "phantom" rate hike from the Federal Reserve (Fed) has served as a catalyst for a series of events throughout the global financial markets, says a report by Quartz; including bolstering the US dollar, which has dampened commodity prices, negatively influenced commodity-producing countries, and put pressure on China to devalue its currency.  The fact that markets have moved so significantly on the back of the mere possibility of a Fed rate hike exposes the fragility of the worldwide financial system, and reveals the problems that central banks face in escaping crisis-era policies such as zero percent policy rates. As the report states, there are five primary investment implications and lessons to take from this year's markets: rates are likely to stay low for longer; volatility will result from the unwinding of crisis-era policies; economic growth, rather than liquidity, is needed more than ever to bolster asset prices; the interconnectivity of global markets is greater than widely understood; and, divergent central bank policies reflect the multi-speed global economy.  

Many investors are familiar with the adage, “they don’t ring a bell,” to warn when it is time to get in or out of an investment. Well, sometimes they do, or so the famed scientist Ivan Pavlov would likely contend. The physiologist trained dogs to salivate at the sound of a bell, having conditioned them to associate the bell with the delivery of food. Pavlov discovered that he didn’t actually have to deliver the food to get the canines to salivate in anticipation.

It is no different in markets, where the anticipation of an event can invoke the same response as the real thing. Market participants seek to discount the future, after all.

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In 2015, market volatility has been rooted in a phantom rate hike from the Federal Reserve, which throughout the year has been ringing a bell to warn markets that it is on the verge of raising interest rates for the first time since 2006. Though it hasn’t happened, the Fed has elicited a typical Pavlovian response, causing markets to shudder at the thought and prompting a very significant chain of events that has rippled throughout global financial markets. While anticipation of the Fed’s rate hike isn’t the cause of market volatility, it has been a catalyst. For example, it has bolstered the US dollar, which dampened commodity prices, negatively influencing commodity-producing nations, and also put pressure on China to devalue its currency.

That markets have moved so significantly on the prospect of a Fed rate hike exposes the fragility of the global financial system, which remains mired in a lengthy era of deleveraging (Figure 1*). It demonstrates the difficulty that central banks face in escaping crisis-era policies, including zero percent policy rates. In fact, as former Fed Chair Ben Bernanke has reminded us at our quarterly cyclical forums in Newport Beach, no nation has ever successfully escaped the zero bound in the postwar era.

There are five primary investment implications and lessons for investors to draw from this year’s tumult in the global financial markets:

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Rates are likely to stay low for longer

In keeping with PIMCO’s New Neutral thesis, the Federal Reserve has demonstrated that it is likely to take a very gradual and cautious approach to its normalization of interest rates. Policy rates, globally, are likely to stay low through the rest of the decade, supporting equity and credit markets, as well as real assets.

Volatility will result from the unwinding of crisis-era policies

Markets have become accustomed to, and somewhat dependent on, central bank support. Even the threat of removal can cause upheaval in markets.

Economic growth, rather than liquidity, is needed more than ever to bolster asset prices

With the Fed no longer adding financial liquidity into the US financial system, and the Fed’s balance sheet shrinking as a percentage of the US gross domestic product, investors are likely to focus more than ever on economic growth and company cash flows when making investment decisions.

The interconnectivity of global markets is greater than widely understood

When constructing an investment portfolio, we believe it is important to focus on risk factors (equity, interest rate, and currency, for example), and to understand how financial instruments might correlate to each other under various scenarios (including stress scenarios) in order to optimize return prospects.

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Divergent central bank policies reflect the multi-speed global economy

In the current global economic recovery, many nations are on different paths or moving at different speeds along the same path. As demonstrated in 2015, this presents investors with a broad array of both risks and opportunities requiring active management of portfolios in order to optimize portfolio returns in a low-returning investment world.

Whew – all of that from a central bank that took no policy action this year! Pavlov certainly was on to something.

For more insights on markets and investing, visit our PIMCO blog .

Mr. Crescenzi is an executive vice president, market strategist and generalist portfolio manager in PIMCO’s Newport Beach office, and a member of the Investment Committee.

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This article was written by PIMCO and not by the Quartz editorial staff.

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*Note: The Bloomberg US Financial Conditions Index tracks the overall level of financial stress in the US money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms. All of the indicators included in the composite BFCIUS index are normalized by subtracting the mean and dividing by the standard deviation for each series. The mean and standard deviation are calculated from observations during the pre-crisis period, which is defined as the period from 1994 to July 1, 2008. The normalized values are then combined into the composite BFCIUS index, which is itself normalized relative to its pre-crisis values. As such, the BFCIUS index is a Z-score that indicates the number of standard deviations by which current financial conditions deviate from normal (pre-crisis) levels.