The deceptive calm of financial markets

Financial markets may appear tranquil, but the reality is that they are wildly distorted by low interest rates. The prospect of restrictive US monetary policy will throw Australian markets into uncharted territory.

Even as Australian politics reaches new frenzies of fiscal conflict, the financial markets are a sea of tranquility. Monetary policy, in stark contrast to fiscal policy, is becalmed. No one expects anything much to happen for a year, either here or where the real decisions are made in Washington.

But appearances can be deceiving: neither fiscal nor monetary policy is as it seems.

In Canberra it is just modern politics as usual, with each side concocting ever more outrage in order to be heard above the clamour of the other. Politics has become a noise-equalising machine, and the media are the willing amplifiers.

The budget is neither as good nor bad as declared. Fiscal policy is slightly tight over the period that can be usefully forecast and long-term spending cuts have been announced that would see a surplus in a decade while at the same time returning bracket creep to taxpayers.

While there can be argument about some of the details (something of an understatement), the broad fiscal settings are basically sensible and moderate.

Monetary policy, on the other hand, is wildly distorted. Financial markets might be calm but they are calm in a ‘Truman Show’ world where cash earns nothing and in Australia 2.5 per cent -- the lowest rate in 50 years. At some point, markets will bump up against the painted sky.

In any properly functioning market, the clearing price is discovered. In today’s money market, the price is imposed, to reward borrowers and punish savers. Central banks have decreed that there are too few of the former and too many of the latter, and see it as their duty to even things up by manipulating the price.

The tension is terrible. Nine months ago it erupted into what remains known as the 'taper tantrum', when prices suddenly fell on the realisation that the Federal Reserve would slow down its money printing at some point, resulting from some ham-fisted Fed pronouncements.

The Fed then “recalibrated its guidance”, as the druids of this cult put it, and things calmed down. So calm are they now that the index of volatility (the Vix) both in Australia and the US is at a record low.

This is normally the time to worry. Historically, complacency always precedes the greatest danger.

In the United States, the only question that matters is when interest rates will start rising. That used to be the case in Australia too until the fiscal frenzy got cracking and produced a slump in consumer sentiment. Most economists still expect the next move to be up, but one or two voices are now wondering whether it might be down.

In Europe, where inflation is still falling, the European Central Bank is now flagging more stimulus -- as early as next week.

The consensus in the US is that rates will start rising next year, probably in the second half of the year, although some recent speeches from Fed officials have suggested it might be in the first half.

For Australia, this cannot come soon enough. Our relatively high cash and bond rates (2.5 per cent versus zero and 3.75 versus 2.5 per cent) is keeping the exchange rate high and preventing the currency from acting as a ‘shock absorber’ to ease the economy’s transition from resource investment to other employment.

In both Australia and the US, inflation is rising as many commodity prices rise, housing rents go up and better-off consumers prove willing to pay higher prices.

The threat of deflation has passed, and although bond yields have been falling in recent months as investors take money off the sharemarket table and park it in the safety of bonds, central bankers are now actively talking about their exit from the Great Distortion.

Monetary tightening always causes a bear market and a recession. It’s how the system works. Lower rates induce a boom; tightening, a bust.

Last week, the President of the New York Fed, William Dudley, explained that this time around that the “equilibrium” interest rate (that is, undistorted) will be lower than previously because the Great Recession (what we called the GFC) “scarred households and businesses­ -- this is likely to lead to greater precautionary saving and less investment for a long time”.

Higher capital requirements for banks will also tend to produce a lower long-term interest rate, and so will the ageing of population because of lower participation and productivity.

It means monetary policy will likely become restrictive more quickly.

The next 12 months are uncharted territory for financial markets, as central banks begin to exit the Great Distortion.

Australian politics, in contrast, has become all too charted.

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