Money Lords Massively Threaten Markets

Think the Fed’s job is tough? At least the US Federal Reserve can focus on fighting inflation. In Japan and Europe, central banks are fighting the markets, not just rising prices. This leads to some very strange, even contradictory policies.

The difficulties of the three central banks mean that investors must prepare for the type of low-probability, high-threat risks that lead to extreme price movements. When central banks backtrack unexpectedly, watch out. Let’s review the risks.

The Fed failed to stem inflation because it spent too much time looking back, as part of its “data-driven” policy, and therefore kept rates too low for too long . By sticking to the data-driven mantra, he risks repeating the mistake in the opposite direction, increasing the risk that he will cause the next recession and have to do a 180. Given that markets have barely started pricing in a recession and therefore a fall in earnings, that would hurt.

On Wednesday, Fed Chairman Jerome Powell went even further, saying he would not “declare victory” on inflation until inflation had been falling for months. Since inflation typically peaks at or after the onset of a recession, it is difficult for the Fed to stop tightening.

Mr. Powell talked about empirically determining what level of interest rates slows the economy enough. My reading of this is that the Fed is committed to keep rising until something breaks.

The European Central Bank has a familiar problem: politics. On Wednesday, the ECB held an emergency meeting to address the problem of Italy and, to a lesser extent, Greece. The ECB wants to dampen the rising heat of Italian bonds, where the 10-year yield rose to 2.48 percentage points above that of Germany before falling after the ECB’s action.

Unlike a decade ago, when Mario Draghi, then head of the ECB and now Italian prime minister, pledged to do “whatever it takes”, central bank action came before that a fire does not break out, which is commendable. But the interim measure of redirecting some of the maturing bonds purchased as part of the pandemic stimulus to troubled eurozone countries is relatively small.

The ECB has promised to speed up work on a new “anti-fragmentation instrument” as a long-term solution, but this is where it comes up against politics. The rich north has always demanded conditions in return for injecting money into troubled countries, to ensure that they do not use falling bond yields as an excuse for even more unsustainable borrowing. But until the flames engulf the economy, troubled countries don’t want the embarrassment — and political catastrophe — of accepting surveillance from the International Monetary Fund or the rest of Europe.

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It will be difficult for the ECB to buy bonds in Italy to keep yields low while raising interest rates elsewhere. At the very least, it will have to impose a stricter policy on other countries than it otherwise would. At worst, he will take the existential risk that Italy will one day default, as Greece did, crushing the ECB’s finances. Both are politically toxic.

Currently, the inflation problem in Europe is different from that of the United States, because wages are not soaring. But if Europe follows the United States, rates may have to rise so much that slow-growing Italy will struggle to pay interest on its public debt, which stands at 150% of gross domestic product. no matter how much the ECB squeezes the Italian spread over German bonds.

Even a small risk of Italy running into trouble justifies dumping its bonds, as higher yields become self-fulfilling. When higher yields increase the risk of default, they make bonds less attractive, not more attractive. Left to their own devices, the market would continue to drive them up in an endless spiral.

The Bank of Japan is also battling the markets, although it has a better chance of winning than the ECB. Investors bet that the BoJ would be forced to raise its cap on bond yields, known as yield curve control. In principle, the BoJ can buy unlimited amounts of bonds, so it can maintain the cap if it wishes. But if investors thought inflation justified higher yields, the BoJ would have to buy ever-increasing amounts of bonds because investors wouldn’t want them, as the economist lamented. Milton Friedman pointed out in 1968.

Japan has the best case of any major developed country for an accommodative monetary policy. While inflation is above 2% for the first time since 2015, it is almost entirely due to rising global energy and food prices, and there is little pressure for higher wages. Excluding fresh produce and energy, annual inflation was 0.8% in April, which is hardly cause for panic.

Yet inflation is on the rise and the risk is growing that the BoJ will have to give in, causing a dramatic change in bond yields – the kind of change that can ripple through global markets. When the Swiss central bank dropped its monetary cap in 2015, several hedge funds that had bet it would stick to its guns were hit hard, and some were forced to close. Japan is far more important than Switzerland, which itself rocked currency markets last week with an unexpected rise in interest rates that sent the franc up sharply.

This gloom could be avoided – central banks are pretty smart. But major mistakes are more likely than they used to be, which means the risk of extreme events in the markets increases. This calls for caution on the part of investors.

Write to James Mackintosh at [email protected]

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