A lot changed over the past 4 days, starting with Draghi’s unexpectedly hawkish speech earlier this week (subsequent ECB clarification notwithstanding), followed by a barrage of hawkish Fed speakers – including Yellen – all of whom warned that risk assets are overvalued, then the heads of the BOE and BOC, who also came out surprisingly hawkish and warned rates hikes are coming, and finally the conclusion of the ECB’s forum in Sintra, where the hawkishness was palpable. In short: coordinated global central bank tightening, or at least jawboning.
As Reuters put it this morning, “the world’s top central bankers have delivered what seems to be a collective message this week that quantitative easing is being put back in its box and interest rates are going up – and global markets are taking note.”
Until then at least, stock and bonds had again been trading higher on the premise that the total pot of global liquidity was still swelling despite rising Federal Reserve rates – courtesy of ongoing European Central Bank and Bank of Japan bond buying programmes, most of all. That’s why Mario Draghi’s apparent change of tack on Tuesday had such an impact on every global asset from Wall Street to London and Tokyo – far more than any of the latest Fed utterances.
German Bund yields, a proxy for core Europe’s borrowing costs, doubled, spreads between U.S. debt and almost everywhere else tightened, and a number of big banks declared the dollar rally dead as the euro EUR put it to the sword.
Suddenly, the usual central bank noise has suddenly harmonised over what the Bank for International Settlements – where dozens of central bankers met at the weekend – called the “great unwinding” of easy money.
Of course, one can be contrarian, and say that central banks have decided to hike rates, in the process blowing up long-rated yields and sharply steepening curves, at the worst possible time: when private sector loan demand growth has collapsed to zero, when debt charge offs are suddenly spiking, when US GDP can barely rise above stall speed, when China is rapidly removing liquidity from the market and deleveraging, when the global credit impulse has crashed, and – most importantly – when any drop in risk assets will send recessions odds surging.
In any case, however one explains the sharp change in central bank rhetoric in the past few days, one thing is clear: as Deutsche Bank’s George Saravelos writes today, developments over the last two days provide numerous signals to argue for three important regime shifts in markets away from the low volatility equilibrium.
Here are the three shifts he envisions:
- ECB liberation – President Draghi’s speech on Wednesday was important not because he marked a hawkish shift to policy but because he implicitly signaled that the ECB is not as concerned about low inflation any more: it is now considered temporary. The language shift is critical because it “liberates” the euro, disinflationary strength in the currency may now matter less for the ECB. This language shift coincides with another regime change that has been evolving in recent months and is even more important: the complete breakdown of EUR/USD with rate differentials suggesting the ECB was losing control of FX anyway. Both these observations are critical because they suggest that the euro can strengthen despite, not because of higher bund yields. In fact, the more the euro appreciates the more ECB tightening will be slowed. The key driver of euro strength is not ECB hawkishness but medium-term rebalancing of structural postcrisis underweights in European assets. The ECB may not able to do much about it.
- Fed zombification – in the meantime we have another regime shift in play reflected in the market persistently ignoring Fed tightening in both action and words. The key to understanding this behavior is that unlike other central banks the Fed is approaching its own assessment of the nominal neutral rate at 2%. While this is not priced for next year, the market is already priced for a terminal rate slightly below 2% further out the curve. Even if the tightening happens sooner rather than later, the crux of the argument is that unless the market believes the Fed is running behind the curve (eg. US inflation acceleration) tightening will continue to look more like easing: the more the terminal rate approaches, the higher the odds of a Fed “pause” or “time out” until the productivity or inflation pictures improve more.
- Global co-ordination – the final shift emerging is a co-ordinated shift from developed world central banks in a more hawkish direction, all apparent in rhetoric from the ECB, Fed, Bank of Canada, Bank of England and likely others in coming weeks. This global co-ordination was implicitly confirmed by Draghi’s little-cited comment in the central banker Sintra panel yesterday where he noted the importance of G20 central bank co-ordination in keeping market volatility low. The implicit message here is that if all central banks sound hawkish at the same time then divergence, and therefore FX volatility, will stay low. The problem with this convergence however is that the Fed is already in tightening flight mid-air with other central banks just about to take off the runway. With the next big question