Rate-Rise Fears Trip Up Markets

Major markets had one of their worst days in months, as doubts over central banks’ willingness or ability to stimulate economic growth sent stocks and bonds tumbling.

The Dow Jones Industrial Average fell nearly 400 points, and sinking bond prices pushed yields on government debt to their highest levels since early summer. The yield on Germany’s 10-year bund, which had been negative almost without exception since Britain voted to leave the European Union on June 23, popped into positive territory Friday.

The wave of selling shattered weeks of summer torpor and was a reminder of the extent to which long-running rallies in stocks and bonds are reliant upon continued support from central banks.

The European Central Bank damped market sentiment on Thursday by deciding to leave its bond-buying and interest-rate policies unchanged, rather than expanding them as some investors had hoped.

An official with the Federal Reserve deepened concerns by suggesting Friday that the Fed still might raise interest rates even after a week of relatively weak U.S. economic data.

“A reasonable case can be made for continuing to pursue a gradual normalization of monetary policy,” Federal Reserve Bank of Boston President Eric Rosengren said in a speech.

The Fed has begun preparing for a Sept. 20-21 policy meeting and faces a close decision about whether to raise rates at that meeting or wait until later in the year to move.

Mr. Rosengren, who has tended to support keeping rates low in the past, helped push markets into a deeper rout. The Dow industrials plunged 394.46 points, or 2.1%, to 18085.45. The S&P 500 declined 53.49 points, or 2.5%, to 2127.81. The percentage drop was the biggest for both indexes since June 24. The Nasdaq Composite Index lost 133.57 points, or 2.5%, to 5125.91.

Yields on 10-year Treasury notes jumped to 1.671%, their highest level since June 23. Bond yields rise as prices fall.

“Once the snowball starts rolling down the hill, everybody jumps on board,” said Jonathan Corpina, senior managing partner at Meridian Equity Partners.

Some traders called the retreat a rational breather after a long period of relative stability. Mixed economic data means major central banks are likely to maintain their easy-money policies. Still, the reaction shows how jittery investors can be when that support faces any uncertainty.

Worries that stayed the Fed’s hands earlier in the year—including potential fallout from the U.K.’s decision to leave the European Union and a couple of weak jobs reports—have dissipated, giving them an opening to raise short-term interest rates. Meanwhile, the economy isn’t expanding so fast or inflation clearly rising rapidly enough to give them a sense of urgency about moving rates higher.

“We have the ability to be patient,” Robert Kaplan, president of the Federal Reserve Bank of Dallas, said in an interview with The Wall Street Journal Friday.

It is up to Fed Chairwoman Janet Yellen, who said in August that the case for raising rates had strengthened in recent months, to steer a divided central bank toward a consensus.

Others have suggested there is still time to wait.

“We have an opportunity to continue to get employment gains in this country,” Fed governor Daniel Tarullo said in an interview with CNBC Friday. He said he expected a “robust discussion” at the September meeting about whether to raise rates.

Fed governor Lael Brainard is scheduled to speak on Monday, a day before officials at the central bank will stop making public comments ahead of their meeting.

Federal-funds futures, which are used by traders to place bets on central-bank policy, on Friday showed a 24% chance of a U.S. interest-rate rise in September, compared with an 18% chance as of Thursday, according to CME Group Inc. The expectation for a rate rise by December rose to 55%, from 51% on Thursday.

While traders try to assess the chances that the Fed will raise rates, they are also looking to Europe and Japan for clues about the path of monetary policy in those markets. Officials at both of those central banks have pushed interest rates into negative territory and are buying up bonds to push them down even further.

Those steps have helped pull down yields on government debt around the world. Investors, however, are concerned the ECB and Bank of Japan are getting closer to the limits on bonds they can buy under their programs.

The ECB Thursday decided not to expand its bond-buying programs, despite its concerns about persistently low inflation and sluggish economic growth.

ECB President Mario Draghi, however, left open the option of future action. He has asked the ECB staff to explore ways to adjust its bond-purchase programs. The Bank of Japan, which meets the same week the Fed does, is weighing whether to add to its own stimulus efforts.

The support is crucial. Investors in some countries have been paying more for government bonds, and even some corporate bonds, than they will get back when the debt matures.

That makes little sense unless they believe buying by central banks will keep pushing the price of debt higher and yields lower. Otherwise, the math on longer-dated debt means rising yields can lead to big losses.

Investors pushed down prices across a range of sovereign debt Friday. German 10-year government bond yields rose into positive territory. That means that investors buying these securities will once again get paid to hold them to maturity.

Yields on British government bonds rose more than those of Germany’s. Ten-year Japanese yields moved back up toward zero, having spent the bulk of the year in negative territory.

The CBOE Volatility Index, which is based on S&P 500 options prices and measures investors’ expectations for stock swings in the next 30 days, jumped about 40%, to 17.50, its highest level since late June.

“What a strange world we live in. For a long time people thought it was surreal yields were negative and now think it’s surreal they’re positive,” said Seamus Mac Gorain, global rates portfolio manager at J.P. Morgan Asset Management.

Source : http://www.wsj.com/articles/rate-rise-fears-trip-up-markets-1473462332

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