COMMENTARY
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Central banks tread on thin ice as markets question hawkish tilt

Make no mistake, the European Central Bank and the Fed are heading towards a major showdown with markets in the coming months.

PUBLISHED : Monday, 11 September, 2017, 8:56am
UPDATED : Monday, 11 September, 2017, 10:42pm

Ever since the European Central Bank raised expectations at the end of June it would soon begin debating plans to scale back its asset buys, international investors have started to seriously question the rationale behind the withdrawal of stimulus by the world’s leading central banks.

The ECB more was seen in response to the strength of the euro zone recovery. thereby joining the US Federal Reserve in normalising monetary policy.

The glaring disconnect between steady – and, in the case of the euro zone, increasingly robust – economic growth and worryingly subdued inflation is fuelling concerns in financial markets that the two leading central banks are jumping the gun in calling time on their ultra-loose monetary policies.

The anxiety about the removal of stimulus has quickly risen to the top of the list of investors’ concerns.

According to the latest Global Fund Manager Survey published by Bank of America Merrill Lynch last month, the biggest “tail risk” in markets (a major event that causes a sharp and sustained deterioration in sentiment) is a “policy mistake” by the Fed and/or the European Central Bank.

The second-biggest risk, moreover, is a crash in global bond markets – quite possibly triggered by a major misstep by one of the leading central banks.

The risk of a crash in global bond markets – quite possibly triggered by a major misstep by one of the leading central banks – increased markedly following an admission by ECB president Mario Draghi that the recent surge in the euro, up more than 14pc against the dollar this year to its highest level since January 2015, “represents a source of uncertainty”.

Last week, the risk of such a blunder increased markedly following a candid admission by European Central Bank president Mario Draghi that the recent surge in the euro – the single currency has shot up more than 14 per cent against the dollar this year to its highest level since January 2015 – “represents a source of uncertainty”.

The stronger single currency has brought about an unwelcome tightening in financial conditions in the euro zone, threatening Europe’s exports and making it even more difficult for Europe’s central bank to hit its 2 per cent inflation target.

Yet not only did Draghi’s half-hearted attempt to talk down the euro fail to counter the disinflationary rise in the single currency, the European Central Bank president announced he intends to set out plans to wind down, or “taper”, the central bank’s two-and-a-half-year-old quantitative easing programme next month, putting further upward pressure on the euro.

Investors are rightly asking themselves why Europe’s central bank is so eager to begin normalising monetary policy when the soaring euro is putting its inflation target further out of reach.

If this does not have the makings of a policy error, then what does?

An indication of the extent to which investors question the hawkish tilt in European monetary policy can be seen in interest rate futures markets which are now pricing in only a slightly more than 40 per cent chance that the central bank will raise interest rates by the end of next year. In March, the probability of a rate rise in the euro zone next year was as high as 90 per cent

Markets are also questioning the credibility of the Fed, which is leading the way in removing stimulus.

With the US central bank’s preferred measure of inflation stuck at just 1.4 per cent, well short of its 2 per cent target, futures markets are pricing in just a 20 per cent chance of a rate hike in December, down from more than 55 per cent in February.

Investors are increasingly sceptical whether even a moderate withdrawal of stimulus is warranted in view of stubbornly low inflation readings

More tellingly, the gap between the yields on benchmark 10-year US and German government bonds – a measure of the perceived hawkishness of the Fed relative to the European Central Bank – has shrunk to 175 basis points, down from 235 at the end of last year.

Even the Fed’s own policymakers are deeply divided over how to respond to persistently subdued inflation. Last week, Lael Brainard, a Fed governor, said she was concerned the weakness in consumer prices may not be transitory and may instead be “driven by depressed underlying inflation.”

Yet at its next policy meeting on September 19-20, the Fed is expected to take a further step towards tightening policy by announcing the start of the process of unwinding its $4.5 trillion balance sheet.

Make no mistake, the European Central Bank and the Fed are heading towards a major showdown with markets in the coming months.

Even though both central banks have gone to great lengths to stress the gradual process of policy normalisation, investors are increasingly sceptical whether even a moderate withdrawal of stimulus is warranted in view of stubbornly low inflation readings.

As the fund manager survey reveals, markets are hyper-sensitive to shifts in monetary policy.

If central bankers fail to convince markets of the soundness of their policies – or worse, frighten investors - a more severe “taper tantrum” than the one triggered by the Fed in 2013 could materialise.

The European Central Bank and the Fed are treading on thin ice.

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