They say breaking up is hard to do. And one of the reasons it gets so complicated when a couple splits is that it impacts all of their other relationships.
Last spring, Gwyneth Paltrow and Chris Martin sent tongues wagging by announcing their "conscious uncoupling" wherein the two stars would gently separate to avoid disrupting the world around them. Katherine Woodward Thomas, a psychologist and author who coined the phrase, helped explain its meaning: "Each party has brought to the dynamic a set of patterns that they've been living inside of for years" that they must recognize impacts their interactions with partners.
While conscious uncoupling commonly refers to domestic partnerships or marriages, it could easily be applied to the US economy and its trading partners. Following the global financial crisis, many developed nations were on the same path. They faced the same problems—high debt and low growth. Often, they fought these challenges with the same solution: highly accommodative monetary policy. Today, the US economy is strengthening. Recent data, including an encouraging September jobs report, show a widening gap between the United States and other developed nations.
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How We're Connected
With regard to monetary policy, the Federal Reserve has become less accommodative, with its third round of quantitative easing ending this month. While the US economy is uncoupling from other economies, it needs to do so carefully given that it remains very closely connected. For example, one would assume that the dialing down of US monetary accommodation would result in higher interest rates, but it hasn't. That's because what we do from a policy standpoint affects other countries and vice versa. Indeed, Fed tightening has historically hurt capital flows into emerging markets.
Elsewhere, since the recovery in the euro zone has weakened, its monetary policy has become more accommodative. It appears that higher yields have prompted some investors to flock to US Treasuries as a more attractive alternative to sovereign debt, such as Germany's bund. In addition, geopolitical crises far from American shores may also be playing a role in the popularity of Treasuries.
As the Fed mulls a move to consciously uncouple from other developed nations by tightening, it must consider the consequences for other nations. First and foremost is the US dollar, which is rallying relative to the euro and the yen. Fed tightening is likely to drive the dollar even higher, which has obvious implications for international trade. The rising dollar—a "de facto" tightening of policy—also appears to be pushing commodity prices lower. This drop in prices is alarming to some investors because it may suggest that global demand is weakening.
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In addition, the Fed could see long rates continue to be held down by demand from foreign investors even when it begins to raise short-term rates. That could easily result in a flattening yield curve or even the dreaded inverted yield curve, which has been known to unnerve investors.
Timing Is Everything
Adding to the need for delicacy in its divergence, is the possibility that the Fed is in a race against the clock. Central bankers need enough time to test the tools in their policy toolkit to ensure the Fed will be able to successfully raise rates. That should take at least several more months, especially given that last week the Fed's "reverse repo" test was apparently unsuccessful.
At the same time, the Fed wants to have enough confidence that the recovery is on solid footing before it begins tightening. The Fed has somewhat of a short window to gain such conviction because it needs to act before any dangerous side effects, such as asset bubbles, are created.
Waiting too long to act could open the door for the recovery to be negatively impacted by slowdowns in the euro zone, China or other areas. If the US economy begins to sputter, then it will be a lot harder for the Fed to raise rates. Why? Because a rate hike may cause instability in markets, even though keeping the tap on becomes increasingly dangerous.
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In essence, we can't ignore that the US economy is one piece of a much larger global economy. We must execute monetary tightening thoughtfully as risks and unintended implications abound. Now, more than ever, it will be important to look for guidance from the minutes of the last FOMC meeting, which will be released on Wednesday.
In terms of sentiment, there seems to be a crisis of confidence that's causing investors to lose their appetite for risk. Things don't feel right for many investors. There's too much uncertainty. However, it's important for long-term investors to look beyond their feelings on short-term risks. Time horizon should be an important factor for investors. And unlike the Fed, time is on their side.
Kristina Hooper, CFP, CAIA, CIMA, ChFC, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.
A Word About Risk: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.
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The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.
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AGI-2014-10-06-10676
