World markets are at a crossroads, nowhere more than in the US, where equity, bond and Fed views continue to diverge sharply. The Fed may have capitulated briefly four months ago, coming belatedly into line with market views of a low rate trajectory, but this was always going to be temporary, given the resilient manner of the US economy’s recuperation.

Last week we saw the first definite signs this temporary Fed capitulation to market wishes has come to an end as sentiment has started to shift, and will do some more shortly in preparation for when the Fed resumes its liftoff. This time it is equity & bond markets that will have to face the music and come into line with Fed thinking & actions, with currency (Dollar, weak EMs) & commodity markets (all sorts) also required to adjust.

The prevailing market view has been bearish.

For some equity investors the bearishness is temporary as company earnings have been badly hit by oil and the Dollar. But these two have now reversed, and as a result earnings will rebound over coming quarters. So dry those tears.

Most fixed income people are perma bears, focusing on unquantifiable risks clouding the macro US prospect (China, elections, high global debt, the Dollar & oil if the Fed raises later this year). It suggests a secular stagnation, with many downside risks, not least a hard landing in China.

They worry too much?

What this shows up most markedly is that investors are bearish for different reasons, some temporarily, others more permafrost, but all together telling each other deeply troubling stories.

The striking thing about all this is that this universal bearishness is not in tune with the story told by the Fed. The latter hears about all the risks, but at the same time remains (opportunistically) data dependent. And the incoming data is simply not as bad as all these tearjerker stories.

The market notes that the Fed has predicted strong growth for many years, and it simply didn't happen. So why should it believe the Fed now. That is dangerous reasoning. For 99 years no flood. But have you heard the one about the 100 year flood? At some point the Fed’s ship will sail in. And then what?

A deeper problem underlying this market/Fed view divergence is how either party thinks about the economy.

The Fed thinks about full employment, full capacity and what that will do. The market begs to differ. The market actually welcomes an acceleration in growth, earnings & jobs, in other words above-trend growth. It sees it as catch-up, not as a cause for concern.

The difference in thinking about a spell of above-trend growth is that the Fed sees a full employment economy colliding with supply shortages, lifting wages & inflation. The Fed wants to act well ahead of this moment, preferring to raise rates early and cool things down to design speed rather than staying too long at above-trend, trying to absorb resources that are no longer easily obtainable, unless wooed.

As reality plays out, data improve (GDP growth) and deteriorates (inflation lifting), markets will need to grapple with the possibility that the Fed WILL start raising again, probably not in June (Brexit), but likely in July. Not in September (needing more data, and giving the Trump/Hilton show a wide berth), but likely again in December.

Though there will likely be volatility, this should ultimately proceed smoothly if well signposted. The longer the market ignores these Fed overtures, however, the more abrupt things could become.

The US bond market is probably most at risk, because the base effects lifting inflation in coming months could be quite sudden, and the market not ready? Not believing? Convinced of other things?

And so there we continue to face the risk of scrambling when reality connects, in turn sending out disturbing ripples all over the capital universe. Therefore it isn't any longer a time to sit back, but to cover all your bases.

And all this five months before being confronted with a Trump Presidency and the lack of clarity of what that implies for economic policy. Yet winners & losers there are likely to be, aside of mindshifts and what these will do to markets.

Cees Bruggemans

Bruggemans & Associates, Consulting Economists

Website www.bruggemans.co.za

Email  economics@bruggemans.co.za

Twitter  @ceesbruggemans

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Honorary Professor of Economics, University of Stellenbosch