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The primary job of any professional investor in bonds used to be to worry about what might go wrong, just as it was for equity investors to hope that things might go well. Today, you would think, there is even more reason for bond investors to worry when a vast swathe of fixed interest investments are priced to deliver negative real returns, now and into the future.
One of the many strange features of today’s markets is that bond investors nevertheless seem to have transmuted into the market’s optimists (I vowed never to call them greater fools again, given how well gilts and Treasuries went on perform the last time I deployed that phrase). Meanwhile equity investors, to judge by the defensive sectors which have led the market higher this year, remain at heart both fearful and reluctant to believe that prospects might enduringly improve.
Behind this conundrum clearly lies the pivotal role that central banks have played since the global financial crisis in seeking to target and to shape both the yield curve and the level of the equity market. Last week the Bank of Japan joined in the global game of monetary easing with what is by any measure an extraordinarily bold attempt to reignite inflation in a country that last saw inflation above 1% in 1997 – and then only very briefly.
The Federal Reserve meanwhile is agonising publicly over when and how quickly it can try to wean the US economy off the financial heroin of quantitative easing.
Every governor of the Fed has their own view on this subject and keeping tabs on how the balance of opinion is shifting is becoming a full time occupation. (It is mildly paradoxical that the Fed’s new commitment to greater transparency, a central plank in today’s post-crisis central bank orthodoxy, has failed to produce any greater consensus about the speed or timing of its next move).
If US economic data continues to sustain the improvement of the last few months, then it seems possible that the Fed, while leaving its interest rate commitments in place, will seek to start slowing the scale and pace of its QE programme before the end of the year. However seasonal factors play a big part in the reporting of economic data, as well as in company earnings estimates, so any disappointment in the next few months’ data – which tends to happen over the summer months – could easily give the doves a reason to put off the day when policy has to tighten.
We know that Mr Bernanke is concerned from historical experience about the risks of appearing to sanction any premature upward move in bond yields. It seems all too plausible that if there is a bias in policy it will be towards erring on the side of caution, with the attendant risk that hindsight will judge that the Fed, in its urgency to avoid disinflation, has done too little too late to head off an incipient rise in inflation expectations instead.
Given that a number of central bankers have publicly aired their reservations about the wisdom and limits of QE as a policy, and remain (outside Japan at least) concerned about the disproportionate burden of policy adjustment which they have having to shoulder in the absence of fiscal manoeuvre by over-indebted governments, the outlook for financial markets is developing into a serious test of central bank potency.
Having expanded its balance sheet to $3 trillion since the Lehman Brothers debacle, the Fed is approaching the point when its credibility as an anti-inflationary force will begin to be called into question. Dr Robert Gay, a former senior Fed official from the Volcker era, now working in the private sector, ventures for example that it would be hard for the central bank to grow its balance sheet much beyond $4 trillion without starting to sacrifice its authority. If that is right it implies that sustaining asset purchases at the current rate of $85bn a month will start to bump up against its limits before 12 months are up.
As Prof Jeremy Stein, a relatively new member of the Fed, noted two months ago, there are meanwhile some signs that high yield debt and leveraged loans may already be flashing a warning signal about credit market conditions. His point was that while credit spreads in these markets do not yet appear overextended against historical experience, there is evidence that when high yield’s share of credit market issuance rises to new highs, as it did in 2007 and again in 2012, it can point to incipient overheating in the credit market, in this case driven by the global “reach for yield” by income-starved investors.
Something similar appears to lie behind recent developments in emerging market debt. In plain language, the risks of some new credit crisis with potential implications for global financial stability may already be on the increase, and will continue to do so the longer the policy of monetary policy accommodation remains unchanged. The Japanese policy shift is meanwhile designed to bring the same “reach for yield” phenomenon into the Japanese institutional and private investor market for the first time.
In his response to Prof Stein’s thoughtful analysis, Mr Bernanke offered his own analysis of the interplay of monetary policy and long term interest rates, pointing out that market expectations for all three of the main components of the latter – expected inflation, inflation-adjusted short term rates and the term premium – remain low. The Fed chairman thinks that is because the markets judge that future economic growth is going to be persistently low.
Given however that the whole thrust of Fed policy is to influence market interest rates as far out along the curve as it can, and investors are taking its commitments at face value, might not this argument be just as circular as the one with which Mr Greenspan convinced himself there was no crisis in the financial sector leading up to 2008, given his belief that rational investors would never act against their long term self-interest? The more the markets dance to the tune of the central banks, the greater the risk that the central bankers will mistake the message that market prices are sending back to them.
Jonathan Davis 