It took a devastating combination of the pandemic, war in Ukraine and a central banking U-turn on inflation to do it. Since the turn of the year the rules of the game in markets have been dramatically upended. Gone are those notorious acronyms Fomo (fear of missing out), Tina (there is no alternative to higher risk equities and credit) and BTD (buy the dip).
The ecstatic equity market response to what were initially seen as dovish signals in the US Federal Reserve’s tightening move this week quickly evaporated — a mere blip in what is now clearly a bear market. At least sanity appears to be returning to central bank policymaking.
Having offered no convincing rationale for the continuation of their asset buying programmes long after the 2007-09 financial crisis, the central banks are now committed to raising rates and shrinking their balance sheets. That holds out the hope that after years of overblown asset prices and mispricing of risk, the information content of market prices will once again become meaningful.
The biggest indication of a semblance of normality is the decline in the number of negative yielding bonds across the world, down to about 100 compared with 4,500 such securities last year in the Bloomberg Global Aggregate Negative Yielding Debt index.
So the morally hazardous practice of paying people to borrow is on the way out, and the need to search for yield regardless of risk is becoming less intense. Benchmark 10-year US Treasuries are yielding close to 3 per cent, more than twice the level in late November. Since January, equity and bond prices have come down in tandem, so that a conventional 60/40 equity and bond portfolio has offered investors no diversification.
The big question is whether this all marks the end of asymmetric monetary policy, whereby central banks have repeatedly put a safety net under collapsing markets while declining to curb irrational exuberance. In the short term the answer is yes, at least in the US. For as Bill Dudley, former head of the New York Federal Reserve, has remarked, the Fed wants a weaker stock market and higher bond yields. This tightens financial conditions, thereby reducing the need for policy activism.
Yet before becoming too excited about the new thrust of a monetary policy that is being widely described as aggressive, it is important to note that the real policy interest rate remains negative. Core inflation, as measured by the Fed’s preferred personal consumption expenditures price index, stood at 5.2 per cent in March compared with the previous year, while the Federal Open Market Committee lifted the target range of the federal funds rate this week to just 0.75 per cent to 1 per cent. So while policy is being tightened it could scarcely be called tight.
The risk of policy error is high because, as Fed chair Jay Powell admitted on Wednesday, a neutral monetary policy position which neither speeds up nor slows the economy was “not something we can identify with any precision”. The fear is that central banks may precipitate a recession at a time when global debt is at record peacetime levels.
According to the Institute for International Finance, a trade body, global non-financial corporate debt rose from $81.9tn to a phenomenal $86.6tn between the third quarter of 2020 and the same quarter in 2021. This sum, equivalent to 97.9 per cent of gross domestic product, suggests a greater than usual corporate sensitivity to interest rate increases and a serious vulnerability.
It may anyway take a recession to bring inflation back under control. And on Thursday the Bank of England warned that the UK economy will slide into recession this year while higher energy prices push inflation above 10 per cent. Members of the bank’s Monetary Policy Committee are clearly prepared to intensify the squeeze on household incomes in order to address worsening inflation. They voted to raise the main interest rate by a quarter point to 1 per cent, the highest level for more than a decade.
The global economic picture is now darkening further in the wake of the pandemic because of China. Its zero-Covid policy and lockdowns are hurting demand, as have insolvencies in the property sector which is a disproportionately large chunk of the Chinese economy. This is bad news for, inter alia, continental European exporters who are also coping with the loss of the Russian market. The eurozone economy will be hard pressed to avoid stagflation.
For the central banks, this recalls an old joke about a cab driver telling a lost tourist asking for directions: If I were you, I would not be starting from here. The Fed remains confident it can engineer a soft landing. That will require luck as well as judgment, which has not been much in evidence of late. There remains a real possibility of recession, which could breed panic in central banks and thus a return to asymmetric monetary policy and yet more quantitative easing.
In truth, the central bankers are flying on a wing and a prayer. That is less than reassuring for people whose incomes are subject to a brutal contraction, even if it is superficially cheering for investors.
Letter in response to this article:
Dramatic jump in the money supply is the real cause of inflation / From Professor Tim Congdon, Chair, Institute of International Monetary Research, University of Buckingham, Buckingham, UK