Hawks and doves play chicken on central bank decisions
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For markets, 2022 will be the year of playing chicken.
Inflation has raced higher in the past year, well beyond most central banks’ tolerance levels. So the time has come for policymakers to start withdrawing the stimulus that pushed asset prices up after the pandemic first hit, nearly two years ago.
Some central banks have already started removing the support they pumped into the financial system. Among them is the Bank of England which, in December, surprised investors with its first interest rate rise in three years.
And the most influential of them all — the US Federal Reserve — has started trimming asset purchases, as well as signalling that it will deliver three rate rises over the course of the year. Investors increasingly think the first could come as soon as March, and that three could be too conservative. The question is whether the Fed can do that without destabilising financial markets.
Hence, the high-stakes test of nerves. Corporate earnings and economic growth of course matter to fund managers, but the direction of interest rates is the dominant issue across all asset classes.
Policymakers shrugged off surging inflation for close to a year. Whether they will now get tough and stick with their intended rate rises should markets take fright is far from clear. Many investors doubt that policymakers will be brave enough to crank up the cost of borrowing in the face of any blow-ups in asset prices.
“Central banks can’t afford to be aggressive inflation fighters,” argues Salman Ahmed, global head of macro at Fidelity. “It’s not consistent with economic stability because of debt burdens.”
The European Central Bank has some particularly sharp restrictions here, given that its monetary support of the bond market is so crucial to holding the euro currency area together. The Fed has more leeway due to the dollar’s central role as a global reserve currency but, even then, “there is a risk of endangering financial stability”, Ahmed adds.
Public debt in the US stood at about 60 per cent of national output in 2007, Ahmed notes. Now, due in part to the massive fiscal largesse linked to the coronavirus pandemic, it is well over 100 per cent — which in turn means that a huge slice of predicted GDP growth could be erased by higher benchmark interest rates that raise debt servicing costs.
“That’s the elephant in the room,” Ahmed says. “When inflation is below 2 per cent, you can justify being dovish.” In the US, it is now running at 7 per cent, taking that option away.
Already, cryptocurrencies and some of the more speculative areas of stock markets have stumbled since the Fed showed more urgency in its shift to tighter policy, but the impact has not fanned out across markets more broadly.
Some fund managers remain confident that fiscal and monetary authorities can work their way out of this quandary without further disrupting economic growth or markets.
Nonetheless, the past decade shows how tricky this process can be. In 2013, then Fed chair Ben Bernanke sparked what became known as a “taper tantrum”, when he declared an intention to trim regular asset purchases introduced after the global financial crisis of 2008. Emerging markets currencies and bonds, in particular, suffered a heavy blow.
On a smaller scale, in late 2018, current chair Jay Powell suggested that the Fed was on “automatic pilot” towards regular rate rises, triggering tremors across global stocks. Within six weeks, he had changed his tune, urging greater patience. Investors took this as, at least in part, a capitulation to market pressures.
The same tension is present now. Raising rates too late or too timidly could prove to be an act of self-sabotage that leaves future generations struggling to rein in inflation and stores up other problems for the long term.
“For inflation not to become a problem, we need a steep tightening cycle,” says Luigi Speranza, chief global economist at French bank BNP Paribas. He thinks the Fed may have to raise rates faster than investors anticipate.
But acting too soon or aggressively threatens to strangle a global economic recovery that is already vulnerable to the vagaries of the pandemic, and to spark a short-term market shock.
“The bear argument is that, if we were to get a distinct rise in [benchmark bond yields], then everything from house prices to growth stocks goes down,” says Andrew Pease, global head of investment strategy at Russell Investments. Already, double-digit percentage declines in the value of some high-growth but low-profit US technology stocks highlight how hard these fears can bite.
If policymakers repeatedly tighten liquidity and then hit pause, that would line up a year of “buying the dip” in markets, Pease says — already a familiar pattern, particularly since the pandemic struck.
Sliding interest rates and resilient demand for government bonds have meant that yields have declined for the past four decades, boosting the attractiveness of riskier assets. Without a continued downdraft in bond yields, to which many fund managers have grown accustomed over their entire careers, those riskier assets may struggle.
Pease thinks a further decline in yields is hard to imagine, “unless you can see a world where the Fed takes rates to ECB levels, below zero”.
“Look, it’s possible,” he adds. “But, without that, it’s difficult to see what are the fundamental factors that drive down yields further. I can’t see rates really spiking but I think we have had the bottom of that cycle. It looks like it’s over.”
For investors and asset managers, that could make 2022 harder to navigate than the previous year-and-a-half.