Why Central Banks Continue to Put Asset Prices Out of Whack

A protracted exit from easy money will continue to create market puzzles

By Richard Barley
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Even as the world’s central banks edge away from the extraordinary policies of the past decade, huge market distortions remain. The unwinding of years of easy money will continue to puzzle investors.

Take the euro, the dollar and U.S. and German government bonds. They are deeply linked: exchange rates often track expectations for monetary policy, which shows up in differences in yields between bond markets.


VISIONS OF THE FUTURE
Difference between U.S. and German yields


LOOKING UP
How many dollars 1 euro buys




Normally, short-maturity bond yields, closely tied to central-bank actions, would really matter for currencies. But as central banks have sought to influence longer-term interest rates more directly, 10-year yields have gained in importance.

Even this isn’t straightforward, however. Earlier this year, the euro rose and the 10-year yield gap between the U.S. and Germany narrowed, as eurozone economic data proved strong and the European Central Bank signaled it would ease up on the monetary-policy pedal. Both moves could be interpreted as investors rethinking the relative prospects of the eurozone and the U.S.

The euro is still flying, up more than 12.5% against the dollar this year. But the U.S.-German bond spread has widened since September to more than 2 percentage points. The German 10-year yield, at 0.34%, just hasn’t reacted much to the brighter outlook.

Are either bonds or the currency mispriced? Perhaps not. The euro, for instance, might be better able to look at the endgame for monetary policy than current yield differentials. Bonds have still to contend with sizable purchases by the ECB, and forward guidance that rates will stay low for a long time yet.

A measure of future interest rates in the U.S. and Germany—the difference in five-year yields starting in five years’ time—tells a related story. This measure should be less affected by the impact of today’s influential forward guidance, and hence contain more information about where policy might be headed in the longer term. The U.S.-German gap on this measure has a closer fit with what the euro has been doing recently, data from ING shows.

Meanwhile, central-bank policy elsewhere, particularly in Japan, is in the mix. Since the Bank of Japan is holding yields down, Japanese investors need to look elsewhere for returns. But the cost to hedge against moves in the dollar has risen, making U.S. bonds less attractive, notes Lombard Street Research. European bonds may be benefiting from Japanese purchases, holding yields down but supporting the euro.

If markets are all about putting a price on the future, then right now, some markets seem more curious about what lies ahead than others.

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