CONFUSING MARKET SIGNALS CREATE A MINEFIELD FOR CENTRAL BANKS / THE FINANCIAL TIMES

Confusing market signals create a minefield for central Banks

Volatility and investors’ swings on the inflation threat complicates life for bankers unwinding stimulus

John Plender


Something curious is afoot in global funding markets, starting with the much-remarked recent surge in the London interbank offered rate. The difference between Libor and the overnight indexed swap rate has soared to its highest level since the financial crisis. A widening Libor-OIS spread, a seemingly arcane financial relationship, is important, not least because it usually implies stress in the interbank market.

One explanation offered is that US companies are repatriating cash from overseas subsidiaries. Some blame an expansion in Treasury bill issuance that followed the raising of the government’s debt ceiling. Perhaps most plausible is the existence of a wrinkle in the Trump tax reform legislation, which sets limits to the interest deductibility of inter-company financing for foreign banks.

Whatever the explanation, it is the consequence that matters. While it seems unlikely that the expanding Libor-OIS spread portends an imminent liquidity crisis in banking, it is undoubtedly true that Libor-linked borrowing costs on bonds, loans and mortgages are rising.

In effect, private markets are bringing forward the impact of future Federal Reserve tightening. What this underlines, among other things, is the difficulty central banks face as they retreat from ultra-loose monetary policy. Understanding the real economy is hard enough when tight labour markets fail to generate wage inflation and productivity performance is stubbornly poor.

Structural changes in financial markets that throw up confusing market signals are an unwelcome additional challenge. And those signals have been particularly confusing over the past few months on inflation, which is the central banks’ core concern.

From mid-December, investors started to demand increased compensation for taking on duration risk. Through January, rising US Treasury yields reflected a shift in concern away from deflation towards inflation and a demand for further compensation for what promised to be an earlier exit by central banks from unconventional policy. Then on February 2, a stronger than expected US labour market report caused a further rise in Treasury bond yields that had just reacted nervously, against the background of loosening fiscal policy, to the Treasury’s announcement of increased auction sizes for the government’s IOUs.

Equity markets across the world fell out of bed. Yet, paradoxically, the credit markets remained unperturbed with US and European corporate high-yield spreads staying at levels close to their pre-crisis lows. Strange signal.

Equities quickly recovered their losses. Then in March, bond yields started to fall again despite no marked change in the inflation outlook. What on earth, you might ask, was going on.

The turbulence of early February takes some unpackaging. With hindsight the key incident was the jump on February 5 in the Vix index, the measure of volatility implied by equity option prices. It was the biggest daily increase since the 1987 stock market crash.

The rise in volatility meant that traders in volatility exchange traded products had to buy more Vix futures to rebalance their books. As the latest BIS Quarterly Review points out in a revealing account of the episode, volatility increases have historically been sharp, so those betting on low volatility were collecting pennies in front of a steamroller.

There was then a spillover into the equity markets from Vix futures dealers who had hedged their exposures by shorting so-called E-mini S&P 500 futures, thereby putting downward pressure on equities. In addition, notes the BIS, normal algorithmic arbitrage strategies between exchange traded funds, futures and cash markets kept markets tightly linked. Forced sales by momentum traders added to the toxic mix.

In short, what appeared to be a full-scale inflation scare was a modest inflation scare combined with an immodest technical overshoot.

With government bond yields down since February, are investors now over-complacent about inflation? The risk of an overheating US economy remains real, labour markets are tight and commodity prices are up. In a recent speech Gertjan Vlieghe of the Bank of England Monetary Policy Committee put a cogent case that the Phillips curve, which charts the relationship between unemployment and wage inflation, is far from dead.

He highlighted a number of factors that have lowered wage growth for a given unemployment rate such as lower structural unemployment, public sector wage restraint, downward nominal wage rigidity, weak inflation expectations and weaker productivity growth. And he made a good case that several of these wage headwinds were now fading.

The volatility rise in February is probably a pointer to much greater future turbulence. Years of ultra-low interest rates and low volatility have dulled sensitivity to the leverage and currency mismatch risks inherent in ever more widespread carry trading. The exponential growth in derivatives trading means that the embedded leverage in these instruments is an ever greater threat to financial stability. So, too, is the increasing use of mechanistic, pro-cyclical trading strategies. All of which creates quite a minefield for beleaguered central bankers.