The dog days of summer | Calamatta Cuschieri

Mid-August is often referred to as the ‘dog days’ of summer.  The saying arises from the observation, first recorded in ancient Greece, of the arrival of Sirius – the dog star – which is a star brighter than the rest that make up the constellation.  This star is believed to be so bright that the ancient Romans believed the star’s warmth was added to the sun’s heat, causing the hotter, longer days.  For investors, the dog days are generally referred to as the period when people are in vacation mode, corporate earnings and data releases are scarce and trading thins out on major stock exchanges.

However, this seemingly ‘relaxed’ environment for financial markets may not last long.  In fact, in a week’s time the Federal Reserve Bank of Kansas City will host the Fed’s annual gathering at Jackson Hole, Wyoming.  It is a place where central bankers, economists, and journalists from around the world gather to discuss a variety of topics. This year’s main policy debate will definitely be between monetary ‘hawks’ who believe the Fed Reserve (and other central banks) must soon rein in their expansionary policies, and ‘doves’ who believe aggressive monetary easing remains necessary to restore full employment.

The outcome of this debate is hardly straightforward but history suggests that getting it right matters for the markets.  For instance, in May 2013 oblique references by then Fed Chairman Bernanke to tapering sent the bond market into its infamous tantrum.  Sudden shifts are thus best avoided, primarily to minimize the risk that financial markets might seize up.

Gradualism dictates that the first policy step ought to be a slowing of asset purchased (‘tapering’), rather than a sudden stop.  Only after asset purchases have concluded does it make sense to shrink the central bank’s balance sheet.  Even the, it is preferable to first allow maturing assets to roll off the balance sheet before engaging in direct sales of notes and bonds.  Hiking short term interest rates is best left to an even later date.

But all this will only be possible if the macroeconomic environment remains benign.  Both inflation and recession must be avoided if policy shifts can take place smoothly over time.  With inflation nowadays already significantly above the Fed’s target rate of 2%, overheating represents the greatest risk to gradual policy adjustment.  If the Fed delays too long, it may have to respond swiftly to avoid a sustained inflation overshoot – with the risk than an abrupt policy shift could wreak havoc on markets.

Investors also know that the Fed must act with some missing data points.  Leads and lags between employment, wages, prices, and productive capacity are always uncertain, but arguably they are even more so today given pandemic-related dislocations to the economy.

The margin of error in markets is small.  Bond yields are absurdly lower, highlighted by negative real long-term interest rates.  Equity markets are almost as overvalued, in part courtesy of low bond yields.  If the Fed acts too late and thereby stokes fears of inflation, bond prices will slump, interest rates will soar, and equity markets will crush.  But if the Fed moves too soon or too quickly, it could precipitate recession, a collapse of corporate profits, and a stock market collapse.

It is little wonder, therefore, that market participants will be fixated on what Jerome Powell and other Fed officials say at Jackson Hole, as well as subsequent Fed statements, speeches, and testimony over the remainder of the year.  The dog days of summer have arrived.  Best to relax and get some rest from the market action, while that is still possible.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

For more information visit https://cc.com.mt/. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.