Over the past few months, one worry has been at the forefront of many investors’ minds: the threat of a major policy mistake by one of the world’s leading central banks, in particular the US Federal Reserve. In Bank of America’s latest fund manager survey, published on Tuesday, an excessive tightening in monetary policy was cited by respondents as the biggest risk facing financial markets. The surge in inflation and asset bubbles were also a concern. Given that many of the issues which have topped the list of respondents’ concerns over the past several years – the trade war and the 2020 US presidential election, for example – have not stopped global stock markets from hitting new highs, there is reason to be sceptical about surveys of investor sentiment. Yet, there is a difference between a risk that could lead to a disorderly sell-off at some point in the future, and one that has already caused significant damage, or is underpriced and likely to materialise relatively soon. When it comes to the world’s two largest economies, the two threats that stand out are the financial contagion ripping through China’s all-important property sector and the reluctance of investors to position themselves for a more hawkish-than-expected shift in US monetary policy. While the liquidity crisis in China’s real estate industry has yet to pose a systemic threat to global markets, the spillover effects within China have become much more severe, perpetuating the loss of confidence in a sector that contracted 2.9 per cent in the final quarter of last year, the first consecutive quarterly decline since 2008. Having previously been confined to junk-rated developers, the distress has spread to the dollar-denominated debt and shares of high-quality investment-grade builders. Some of the dollar bonds of Country Garden Holdings , China’s largest developer by sales, have plunged to record lows, endangering the company’s access to offshore bond markets and further eroding confidence in the sector. That Beijing allowed the liquidity crunch to last long enough to cast doubt over stronger developers’ access to debt markets raises uncomfortable questions for investors. Not only is it clear, as I argued previously, that markets underestimated the government’s resolve to curb the credit-fuelled excesses in the property sector, the scope for miscalculations on the part of Beijing is increasing. While the government has plenty of tools at its disposal to stem the contagion and avert a sharper downturn, the tensions between efforts to cool the housing market and measures to bolster growth have become much more acute in the past few weeks. Indeed, the loss of confidence in the sector is so severe that it is not clear whether recent signs of more forceful action on the part of Beijing – in particular hints of an easing of restrictions on developers’ use of proceeds from prepaid homes – will help vulnerable builders. In the US, by contrast, the Fed has abruptly shifted its focus from prioritising growth to suppressing inflation, which hit 7 per cent last month. The central bank’s sudden change of tone on price pressures has been significant. In the space of just three months, the Fed has gone from being exceedingly dovish to conspicuously hawkish. On the face of it, markets have adjusted. As recently as early October last year, futures markets were uncertain whether there would be any interest rate hikes this year. This week, however, as many as four were being priced in, with the first one in March. Yet, key gauges of financial conditions in America are close to their loosest on record. Market expectations of inflation over the next 10 years have even fallen slightly this year, and currently stand at 2.5 per cent, close to their level over the past two decades. More strikingly, real yields, which take account of inflation, remain in negative territory. This means that even though the Fed has turned hawkish, markets are betting that a slowdown in growth will result in a relatively shallow rate-hiking cycle that will still manage to keep inflation under control. How far will the Fed go to raise rates? Markets already know the answer Indeed, both the Fed and markets believe inflation can be contained without slamming on the brakes. This is a dangerous assumption. While inflation may well peak in the coming months, it is likely to remain uncomfortably high, especially with oil prices having just hit a seven-year high. The Fed may have to raise rates more aggressively than it anticipates, a risk not yet reflected in bond and equity markets. In China, investors have already had a foretaste of the damage that an inadequate policy response can inflict on the property sector and the wider economy. In the US, the threat of a more hawkish-than-expected Fed is still not being taken seriously enough. Both perils may be exaggerated. But as far as policy errors go, these are the ones that are most worrying. Nicholas Spiro is a partner at Lauressa Advisory