MARKETS ARE COOKING UP RECIPE FOR A CLASH / THE WALL STREET JOURNAL

Markets Are Cooking Up Recipe for a Clash

Investors have hardly blinked as central bankers are turning words into actions

By Richard Barley


FLATLAND
Gap between two - and ten year Treasury yields

Isn’t the storm supposed to come after the calm?

Financial markets have spent a good deal of time fretting about the withdrawal of the extraordinary monetary policy measures taken by central banks. Just the suggestion that U.S. quantitative easing wouldn’t last forever sparked the 2013 taper tantrum. Yet this year, with institutions from the U.S. Federal Reserve and European Central Bank to the Bank of England and Bank of Canada all taking action to rein in monetary largess, investors have hardly blinked.

The key difference this year is that central bankers are turning words into actions. The Fed came into 2016 with a dot plot projecting four interest-rate increases in that year, but only raised rates once. By contrast, if it raises rates again in December this year it will have delivered on its promises: three rate increases and the start of balance-sheet reduction. Yet markets still price in fewer increases next year than the three the Fed has on the cards. In essence, markets don’t buy what central banks are offering.

In Europe, the BOE, which has hinted at rate increases repeatedly in recent years, also has finally followed through—and yet the instant market reaction was that the central bank was “dovish.” The ECB managed to announce a halving of the pace of its bond purchases to similar acclaim.

SIDEWAYS
Change in ten year government bond yields since start of the year

Perhaps remarkably, long-dated bond yields have barely budged: At 2.31% in the U.S. and 0.33% in Germany, 10-year yields are pretty much in the middle of this year’s range, and still extremely low by historic standards. In the U.S., the yield curve has actually flattened sharply as two-year yields have risen, even though higher rates on short-dated paper should be at the expense of longer-dated securities. The persistent absence of higher inflation, as well as a steady drift down in the Fed’s longer-run interest-rate projection help explain the continued allure of longer-dated bonds.

But it also signals a possible conflict with what central banks are doing. Each action comes accompanied by what the market sees as reassuring language, and is couched as being dependent on economic data. That leads to an odd phenomenon: each central bank action is seemingly treated as a discrete event, not as part of a bigger shift. Robust global growth means, however, that central banks are all being encouraged to stick with their change in direction.

Of course, central bankers themselves don’t want to provoke market fireworks—and have almost bent over backward not to surprise. Unperturbed by where central banks are going, bond yields have stayed low, keeping financial conditions loose. This however, may ultimately encourage further tightening of monetary policy, perhaps in part due to worries about financial stability in the future.

The result is a recipe for a clash. If markets are right, then central banks, in particular the Fed, may face a struggle in tightening policy. But if central banks continue to push ahead, investors will be left scrambling to catch up.