Guy Debelle, the Reserve Bank’s assistant governor for financial markets, has caused quite a stir with his comments on Tuesday. His suggestion that volatility is too low, that markets are under-pricing risk and that ‘the sell-off … could be relatively violent when it comes”, has struck a chord with many, especially following sharp drops stocks and commodities.
'Why is this happening?' was the lament. It was a great speech - very interesting if you haven’t read it. Debelle’s specific concern is that markets, especially bond markets, are perhaps under-pricing the risk of rate hikes over the next year or so: “It is not clear to me why there should be more stability in … the discount rate. If anything I would argue the converse, namely there is at least as much uncertainty about the future path of interest rates as in earlier periods.”
In that sense, the concern over a lack of volatility is primarily a concern over why bond yields remain low, and consistently so. A problem, certainly, because as Debelle rightly points out, it’s a phenomenon that exposes the bond market to a sizeable correction when interest rate hikes finally occur. This is something I have warned about consistently for many years.
Having said that, I don’t think there are strong grounds to view market participants as being complacent. Debelle was perhaps a little harsh in suggesting that markets should be less inclined to “accept the central banks at their word” and learn to think for themselves. He said: “In my view, while there is more forward guidance from central banks in place than in the past, investors don't have to believe it!”
The great irony of course, is that this is precisely why market volatility remains low -- because market participants actually don’t believe central banks!
Here’s the problem. As Debelle rightly points out, some markets are a lot less liquid than many suspect. Government bonds, for one. Quantitative easing has distorted this market beyond recognition.
Should central banks attempt to make an exit -- that is, attempt to shrink their balance sheets (sell the bonds they hold) and lift short-term rates -- who in their right mind is going to take the other-side of that trade? Just the threat of it would be enough to scare most private investors off. Buyers would be making purchases with the knowledge that they will take an instantaneous and potentially huge capital loss. The bond bubble could collapse with potentially devastating consequences.
The fact that this hasn’t happened so far, despite the Fed warning that it was getting closer to hiking rates and despite geopolitical tensions elsewhere, is simply because central banks remain the dominant players (directly or indirectly in the bond market) and because short-term rates are still around zero. It pays for banks to borrow short (in the money market or just using printed money from central banks) and lend long (back to government Treasuries), especially when their cost of funding approximates zero. The current set-up has frequently been likened to a Ponzi scheme.
In that sense, the market actually isn’t being as complacent as Debelle and other central bankers around the globe would suggest. Participants are no doubt well aware of all the risks cited by Debelle and others. It’s just that they don’t believe that central banks, having gone to the extraordinary lengths they have to monetise debt, prop up banks, repair balance sheets - and otherwise grease the wheels of credit creation, are suddenly going to ‘shirtfront’ the market and the global economy.
At the first sign of trouble, the printing presses will be ramped up again, and markets know this. Rates will stay low for many years as a result; indeed the San Francisco Fed President (Williams) is already talking about the need for another round of QE.
In all likelihood, it’ll be a stop/start feature for the next decade and there is no doubt that the recent slump in crude and the surging US dollar will provide a disinflationary pulse that will, at the very least, allow the Fed to postpone any monetary tightening for some time. Central banks are going to find it very difficult to extricate themselves from this ultra-low rate world and markets know it.