Swinging Market Pendulum
2014-05-19
Having watched central banks in recent years climb out on a limb with their aggressive unconventional policy supports, with no apparent easy way back, global markets have long been dubious as to how all this would end.
There has been a break in the global weather, however, in recent months, as the weathervane started gyrating rather wildly. Or if you wish, as the market pendulum reached one extreme reading, and then started to swing back, with potentially much further to run, depending on how you choose to read the central bank tea leaves.
Is this yet another twist in the divergence debate, with especially the Fed on a steady course throughout as it has sketched its long-term policy trajectory, but markets first massively diverging in an “overshoot†last year, and now, having recently come back into line with the projected trajectory, possibly diverging anew in a growing undershoot?
Or is the central bank policy trajectory itself bending (lower)?
The primary focus is on the US Fed, but there is also the BoE (UK), ECB (Europe), BoJ (Japan), PBoC (China), BoC (Canada), and so down through the alphabet soup to the lower rankings in terms of global presence and impact. Together quite a cabal.
Fed chairman Bernanke was the one in 2008 who broke glass and ripped the unconventional policy cord only to be used in crisis. It turned out the emergency was a lot bigger and longer lasting than ever imagined.
As with indefinite courses of antibiotics, the economic system starts to respond adversely to too much of a good thing. So the policymaker had to find a way back, as untrodden and full of uncertainty as the way in had been, and possibly worse.
Though eternally grateful for the highs it gave them, observable in every conceivable asset clas, global markets throughout expressed unease that even so much liquidity support didn't really work (get economies back in working order quickly), had decided unwanted side-effects (too much speculation being unleashed anew, besides undermining long-term savers such as pension funds and life insurers) and created future nightmares (the question of whether exiting in one piece rather than burning up).
So a lot of unease that made markets skittish, inclined to search for their own exit, implying a bias towards higher risk premium. This was yet further reinforced by the sizable crowd suspecting an early inflation response and/or growth return under pressure from so much cheap liquidity hosing, fearing the need for a rapid policy normalisation eventually.
Implied was a quick ending to QE bond buying, likely followed by a forced rise in interest rates to pre-crisis levels as traditionally considered "normal" at full employment, reminding of the Volcker treatment in the late 1970s.
All this unresolved anxiety effectively foresaw a financial world on skids once the US economy connected with the road and the Fed had to scramble to get back ahead of the curve.
Mere words, never mind rich cliches, do no justice to the concerns involved, not just among market participants but also among many central bankers.
It was in this context early last year (2013) that Bernanke cleared his throat in public and mumbled something about having to start bond tapering sometime (in other words the first teeny-weeny step in exiting).
Markets took it badly, virtually discounting overnight a large part of what was intended as a journey of many years. What followed was described as a tapering "tantrum". Long-term US bond yields added 1% plus in a matter of days/weeks. The more risky asset classes, such as Emerging Markets (EMs), were heavily sold-off, further intensifying a rerating already sometime underway as the global commodity and EM growth prospects had peaked and risk was being differentiated again more sharply.
That was the most extreme position the market pendulum has reached so far, with the high tide sometime in the 3Q2013.
It was also about that time that the top five EM "Fragiles" were identified, and certified dead on arrival, and yet it was really already after the main panic event had been played out.
What followed was interesting for its unexpectedness. For markets seem to have bet the wrong way. Instead of this crazed pendulum swinging yet further out to even greater risk premium being imposed as the accelerated exit of Fed & other central bank Friends came into view, with the rise in US Treasury bond yields and sell-off in EMs escalating, nothing of the kind materialised.
Instead, in early 2014 Bernanke exited as Fed chair (not quite the same thing), the US economy kept rumbling on very benignly, with growth disappointingly modest and inflation undershooting the 2% aim. Events in Europe, Japan and China were not less benign, with leading central bankers walking the talk, new Fed chair Yellen her usual dovish self (and not untoward so), BoJ's Kuroda remaining in aggressive QE expansion mode, the ECB standoffish while talking itself into market support for staying supportive, and China also acting deeply sensitively.
As a first reading, this lifted pressure on markets to stay cautious, with risk premium dwindling, volatility reversing and testing old lows, in what is now described as "unwinding the tapering tantrum of 2013".
So 2013's alarm was considered after all false, with markets if anything becoming more relaxed again about bonds in early 2014 (instead of expecting a non-stop sell-off and steadily higher yields), the EM Fragiles became the top EM performing clawback acts as currencies firmed anew, equities bubbled, and sensitivity about select (London) property bubbles surfaced anew.
Unwinding a false alarm is one thing, but noises of late are suggesting the global market pendulum may have (a lot) further to swing - the other way from where it was heading last year.
For what follows the "unwinding tapering tantrum"? Is this merely an Indian Summer, the last bit of the annual nice weather before winter sets in with meaning? Or has the entire global central bank exit been mispriced, at least so far?
First things first. Fundamentally, following Reinhart & Rogoff, the world has a hard time recovering after a major financial crisis. And nothing was bigger than the Anglo-Saxon hit of 2007-2009, and the European existential crisis of 2010-2012, with China's overheating and rebalancing act not an afterthought, but also a global factor of note. And EMs generally taking a step back, further reinforcing the global starvation diet.
Repair and recuperation under such conditions tends to be a laboured affair. It translates into slow growth, excessive resource slack, repressed inflation, little credit leverage, and all this taking many years to play.
So the story line that many economies need sustained support to prevent relapsing in the first instance, and if possible get an policy assisted leg-up into faster recovery, is not imagined.
In most instances, government finances were exhausted during the crises proper, and have been in correcting mode ever since, if with regional variations.
The real macro stabilisation and adjustment burden keeps primarily resting on central bank supports, in addition to structural reform policies undertaken by governments where possible.
Whereas markets stay skittish, regularly looking over both shoulders to see whether growth and inflation data will force the Fed (and others) to after all step up the pace of exiting and policy normalisation, accelerating bond tapering and bringing forward a steeper rate hiking schedule, the facts seem increasingly different.
Perhaps even also in the UK where markets increasingly have expected policy acceleration as both growth and property appear to outperform, yet BoE's Carney last week taking a Yellen-type dovish attitude, suggesting the first rise in UK interest rates is likely only in about a year (after the May 2015 UK election?) as underemployed labour (as in the US) needs to become better utilized even as inflation stays low, before starting to lift rates.
In the US, the Fed is still on a fairly determined normalisation schedule, yet there are voices asking whether the Fed is assuming too much (and not dovish enough!).
As things stand, Fed policy remains fairly dovish yet determined. Only modest US growth. Slow resource uptake. Tapering to finish later this year. Slow rate hiking to start during 3Q2015 (August?) and likely lasting through 2018 in search of more 'normal', traditional Fedfunds levels near 3.5%-4% from zero today.
This stance winning through to 2018 would by itself be an enormous victory over the fear syndrome underlying the 2013 tapering tantrum.
And it would promise a transition that might be more shock-free than so far imagined, also for more risky asset classes, such as fragile EMs.
The story line only gets better when throwing Japan, Europe and China (and for that matter trailing EMs) into the pot. All these are either very aggressively supportive still (Japan) or hint at being modestly so (ECB, PBoC), potentially offering a counter thrust to the Fed's exit.
If major global central banks succeed in serially exiting supportive policies, the whole adjustment may yet proceed even more benignly as compared to doing it abruptly and in union.
This is where we are at present even as risky assets get more backing.
What still lies ahead is the possible serious discounting of the idea that even dovish central bankers are still overstating growth and inflation rebound potential, especially Fed, ECB, BoJ and PBoC.
The main idea is that growth overall will remain modest, better labour take-up struggling and inflation not succeeding in rebounding much, with nominal growth in many regions remaining very low.
This may not prevent Fed bond tapering ending this year, but it could delay the start and temper the pace of Fed hiking and the 'new normal' Fedfunds level they end up with in 2019 (below more traditional levels?).
If these thoughts can gain greater market traction, long bond yields may not lift as much as now expected, reinforcing any policymaker signals. Hints of this can already be observed in long bond yields today, with the US 10yr Treasury testing 2.5% again and Bunds 1.3%.
This even more prolonged and benign recuperation schedule might be even more favourable for especially risky assets than currently accepted.
Ex-Fed chairman Bernanke has reportedly made presentations to private investors in recent weeks expressing exactly this view. Labour slack (under-employment) remains extensive, take up slow, fiscal policy restrictive, bank credit growth modest. Fedfunds will not quickly get back to 4%, possibly not in his lifetime. A case for bond yields to remain low, for (very) long.
The ultimate surprise would be new events further accelerating the pendulum swing so far observed.
Instead of looking for economic or financial origins for such an outcome, one may wonder whether geopolitical 'events' would be able to trigger them.
One is looking for a new loss of confidence and/or economic and inflation momentum triggering central banks into prolonging, or even intensifying, their supportive, increasingly unconventional policy stances.
The Ukrainian conflict and any Russian and US/EU worsening relations could weaken European economic performance to the point of potentially forcing the ECB to become a lot more supportive than seen so far, as in the past crisis-driven.
Similar events in East Asia, driven by Chinese actions, could potentially also have such macro-effects in parts of the region, and invite policy reaction.
One would expect the Great Powers to proceed with great circumspection, even stealth, in their dealings, but events in recent months makes one wonder about the state of the '3Ms' in geopolitical relations (misjudgment, mistrust, and that ultimate, miscalculation).
This despite the close modern interdependency binding even large countries tightly together, especially in finance and energy (and high-tech capital goods), making a 19th century geopolitical confrontation a very costly affair and less than rational (except perhaps in extreme national emergencies).
Could all this lead to even lower bond yields (again)?
This possible latter part of the pendulum swing obviously constitutes a tail risk (small probability, big impact). But just how small the chances really are as the big powers keep adjusting to each other only time can tell.
Reference
Robin Harding "Yellen policy on rates needs clarifying" Financial Times 13 May 2014
Cees Bruggemans
Consulting Economist
Bruggemans & Associates
Website www.bruggemans.co.za
Email economics@bruggemans.co.za
Twitter @ceesbruggemans
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