Here’s what could set off a ‘Minsky moment’ in paper assets
Global central banks are questioning their own policies which, at the very least, presages a volatile trading environment in the coming weeks and months
Last Friday proved to be one of the most revealing trading sessions since the world’s main central banks introduced their ultra-loose monetary policies in the wake of the 2008 financial crisis.
United States equities suffered their sharpest daily decline since Britain voted to leave the European Union (EU) on June 23 as two prominent US Federal Reserve officials hinted that interest rates could rise sooner than anticipated. The market-implied odds of a rate hike at next week’s eagerly anticipated Fed meeting currently stand at 22 per cent - just as the rally in global bond markets was going into reverse.
The yield on benchmark 10-year German bonds escaped negative territory for the first time since mid-July while its US equivalent shot up 8 basis points to its highest level since the end of June.
Japanese 10-year yields, meanwhile, as discussed in my column last week, have risen nearly 30 basis points since late July and are now almost in positive territory.
Yet it would be wrong to attribute the jump in yields to a sudden repricing of US monetary policy.
Indeed the most conspicuous feature of the current jitters in bond markets is that they have not affected the most sensitive and closely watched part of the sovereign debt markets: the short end of the US Treasury curve which reflects market expectations of the pace of rate hikes.
The policy-sensitive yield on 2-year US Treasury bonds currently stands at just 0.75 per cent - a tad lower than at the end of last month and 35 basis points lower than at the end of last year.
Put simply, what is happening in global markets right now has little to do with the Fed.
On Monday, another senior Fed policymaker, Lael Brainard, even called for a cautious increase in rates on the grounds that inflation in the US is still significantly below target while economic weakness abroad is weighing on the recovery.
This suggests that the Fed’s closely watched policy meeting beginning next Wednesday is likely to be a distraction from the more important development in markets: the significant risk of a severe loss of confidence in Japanese and European monetary policy.
Last week’s decision by the European Central Bank (ECB) not to provide further stimulus has thrown central banks’ own misgivings about their ultra-accommodative policies into sharp relief.
Investors now face the worst of both worlds: stimulus measures which have not proved effective in lifting inflation rates and, just as worryingly, central banks which appear to be second-guessing their own policies.
Even Brainard’s dovish speech on Monday failed to assuage market concerns. On Wednesday, global stock markets were struggling to recover - emerging market (EM) equities have suffered their sharpest sell-off since late June - while the strain on bond markets was still palpable.
According to the last monthly Global Fund Manager Survey conducted by Bank of America Merrill Lynch (BAML), published just after the ECB’s decision to refrain from providing more stimulus, 54 per cent of respondents believe bonds and equities have become overvalued - a record high for the survey which also notes that “investors see an unambiguous vulnerability to a ‘bond shock’ among risk assets”.
While the jury is still out as to whether the current tremors in debt markets are the prelude to a sharp fall in prices of the kind anticipated by Bill Gross, the prominent bond trader who in June described the unprecedentedly low (and in many cases negative) yields as “a supernova that will explode one day”, a loss of confidence in European and Japanese monetary policies, if sustained, could be lethal for sentiment.
It is no exaggeration to say that over the past week or so, the odds of a dramatic and prolonged sell-off have increased markedly - and at a time when Donald Trump, the populist US presidential candidate, is gaining in the polls.
Still, talk of a rout in bond markets is premature.
On Wednesday, yields on eurozone bonds were already starting to fall again as investors speculated that the ECB will eventually be forced to provide more stimulus to lift the stubbornly low inflation rate.
Even the Bank of Japan, which will announce the outcome of its “comprehensive assessment” of its policies when it meets next Wednesday, is expected to continue its easing policy, possibly by cutting rates deeper into negative territory.
Yet the cat is out the bag. Central banks themselves are now questioning their own policies which, at the very least, presages a volatile trading environment in the coming weeks and months.