The US Federal Reserve raised rates for the third time in six months in June, even though inflation had stayed below its 2 per cent target for much of the past decade. Why? The justification lies with the return to “economic normalisation” (a more normal US growth and credit cycle), a reflationary global environment and easy financial conditions all combining to banish the extreme “tail risks” of a deflationary slump that followed the financial crisis.
Yet markets have been reluctant to heed the call of a return to more normal monetary conditions. Having lagged behind the Fed’s rate tightening and the discussion on shrinking its balance sheet this year, investors are still uncertain about the chances of another — well telegraphed — rate rise this year. A less than 40 per cent probability is attached to this in the fed fund futures market. Investors have also yet to contemplate the effects of a tapered Fed balance sheet for asset markets – from the cost of funding in US money markets and the shape of the yield curve to stock market volatility.
The repeated bouts of bond market tantrums in response to virtually unchanged central bank messaging about removing the liquidity “punch bowl” underline just how unprepared markets are.
Central banks have taken note.
The concerted policy message in the past couple of months has been to caution about complacency in global market valuations, as reflected in unusually low risk premia across assets and geographies.
The Bank of International Settlements warned on June 24 that markets have become “irrationally exuberant”, resulting in ever more risk-taking — fed on a diet of high liquidity, inflated asset prices and depressed market rates — causing investors to ignore rising debt ratios and political risks.
In its latest Financial Stability Report, the Bank of England said “very low long-term interest rates make assets vulnerable to a re-pricing, whether through an increase in long-term interest rates, adjustments to growth expectations, or both”.
Fed chair Janet Yellen has also hinted at an overextended financial cycle, noting rapid growth in stock market valuations that look “rich” by historical standards.
European Central Bank President Mario Draghi also signalled that the balance of risks surrounding the eurozone have shifted away from deflation, which leaves bonds looking expensive. The risk premium on European high-yield bonds over German Bunds has fallen to the lowest since 2007, matching levels that preceded the global financial crisis.
In a nutshell, central banks are not necessarily turning more hawkish, in defiance of their inflation stability mandates. Rather they are clearly signalling that investors are becoming far too complacent about the policy outlook — and that risks financial stability.
This decoupling between economic and financial cycles is where crises are born. It is worth remembering that the last major economic shock came from financial excess in a controlled inflation environment. The Fed’s preferred core PCE (personal consumption expenditures) inflation gauge averaged 2.1 per cent between January 2007 and December 2008.
But this was not a harbour of economic stability. The effects of a globalised debt explosion, a slump in productivity and perceptions of inequality have altered the socio-economic map of major economies, and the political environment in which central banks operate.
The prospect of higher debt and weak productivity growth reducing economic resilience to a financial cycle downturn is now a bigger worry for central banks than a bout of inflation softness. So frothy market valuations, based on investors’ expectations of an indefinitely easy policy outlook, have forced worries about financial stability into the growth-inflation mix that has so far dominated the central bank debate.
That, in turn, has tilted the balance in favour of central banks tightening through the current soft inflation patch. However, when it comes to the Fed policy outlook, market expectations remain unrealistically dovish.
Ms Yellen’s choice to communicate cautiously has avoided causing a “taper tantrum” in the markets. But this has not prevented the Fed from delivering three rate hikes and moving towards commencing “quantitative tightening”, by shrinking its balance sheet, faster than consensus has expected in the past year.
Fed policymakers sent a clear message last week that they are not inclined to delay an announcement on when it will begin unwinding its multi-trillion dollar balance sheet simply because of the softness in inflation.
That bond yields should fall in response to the Fed’s message – just as the dollar depreciation continues and key commodities, such as oil and copper stage impressive rallies – will only strengthen the Fed’s confidence in proceeding with removing the emergency stimulus.
It’s time for markets to catch on.