In a world awash with central bank-provided liquidity, what happens when the taps get turned off?
That’s a question that markets are increasingly conscious of even as the authorities in the US, Europe and now Japan continue to run extraordinarily loose monetary policies characterised by zero or negative real interest rates and quantitative easing, or money printing.
While there is no immediate threat of a reversal of those programs – the US Federal Reserve board has said it will keep rates at negligible levels at least until the unemployment rate, now just under 8 per cent, falls below 6.5 per cent and will continue to buy $US85 billion a month of bonds and mortgages for at least the rest of this year – even the Fed’s members are becoming concerned about the unintended consequences of continuing the program.
One of the consequences of the deluge of liquidity has been the development of what many believe is a bubble in bond and credit markets. Once the Fed started pondering aloud about the wisdom of maintaining its bond-buying program it injected doubt into the market and return-conscious funds started being diverted into equity markets, driving up prices.
State Street Global Advisors' chief economist, Christopher Probyn, in Australia at present, is able to rationalise the rotation from bonds to equities, given that bonds and credit have run about as hard as they can and offer minimal returns while receding perceptions of risk and the hunger for returns have made equities more appealing.
As he says, the US hasn’t fallen off the fiscal cliff, Europe, thanks to Mario Draghi’s ‘’whatever it takes’’ promise has calmed down, China’s economy is picking up and Japan has embarked on a program of large-scale fiscal and monetary stimulus. It’s a ’risk on’ environment.
At some point, however, the central banks will stop printing money and eventually start raising rates to try to head off the threat of inflation. That could create a bloodbath in bond and credit markets and volatility in equity markets. It might also have other, even more widespread effects.
Probyn looks to history as a guide. Between early 1993 and mid 1995 the Federal Reserve raised the Federal Funds effective rate from just under 3 per cent to just over 6 per cent. From mid-1999 until well into 2000 it lifted the rate from about 4.75 per cent to about 6.5 per cent. (A year later it was under 2 per cent, where it remained for the next three years). In 2005 the rate started climbing again, from just over 2 per cent to reach about 5.25 per cent in July 2007.
So, what happened during those periods of relative rapid increases in rates?
In 1994 the Mexican peso crashed in what has become known as the ‘’Tequila Crisis". To fund deficits the government had issued peso instruments indexed to the US dollar. For a number of internal reasons the government decided to let its currency float and it crashed, halving in value against the dollar within a week, forcing a US-funded bailout.
In 1997, with the Fed Funds rate still around the 5.50 per cent level, the Asian Financial Crisis developed after the value of the Thai baht, which had been pegged to the dollar, collapsed and ignited a more general crisis that rolled through the region. The relatively high interest rates on offer in the US as the Alan Greenspan-led Fed moved to head off the threat of inflation has been cited as a factor.
In 2000, of course, there was the ‘’tech wreck’’ in the US, and to some lesser degree elsewhere, as the dot-com bubble burst and Greenspan presided over a fall in the Fed Funds rate from a peak of about 6.5 per cent in mid-2000 to less than 2 per cent two years later.
And then, from around the start of 2005, when the rate was just above 2 per cent, it moved up to around 5.25 per cent by mid-2007, when the bursting of the US housing bubble triggered the global financial crisis.
The correlations are obvious, which means a shift in the direction of US monetary policy in particular, when it finally occurs – the end of unconventional policies and the beginning of new cycle of higher rates – will be a delicate and potentially very dangerous moment given how prolonged and profound the central bank responses to the crisis and the recessions and conservatism it spawned have been.
Mind you, while the Fed might be contemplating the not-too-distant end of its bond purchases, there is no immediate pressure to start tinkering with rates. The eurozone and UK are still teetering on the brink of further recession, growth in the US is anaemic, both the US and eurozone have deep and structural debt and deficit issues and China, while recovering, is unlikely to return to double-digit growth rates while the developed world is stagnating.
Probyn makes the point that developing economies now represent about half the global economy.
He expects them to grow at around 5 to 5.5 per cent this year while the advanced economies grow at a meagre 1.3 per cent. That would produce global growth of 3.25 per cent, with the developing economies contributing 2.75 percentage points of that growth rate. There’s not a lot of pressure to start tightening monetary policies in those developed economies.
The reality that the US and eurozone do have severe structural issues (in Europe’s case, a mind-numbing combination of massive economic, financial and political challenges) makes it unlikely that they will be able to generate anything other than quite modest levels of growth, at best and even if nothing that could go wrong does go wrong.
That may mean that when monetary policies do start to change they will be far more gradual than they have been in the past because the prospects of significant economic growth and inflation in those circumstances are probably quite low.
Given the correlations between US monetary policy and international and even global crises in the past, that might not necessarily be such a bad thing.
Fed and co risk a bond bloodbath
With central banks close to bottoming out and thus potentially changing monetary policy direction, State Street's Christopher Probyn, pointing to history, says we should brace for a bond bubble or similar. But is this time different?
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