When will central banks lose control of bond markets?
I have two subjects on my mind today. One is interest rates and the other is equity markets. I wrote a brief Twitter thread on how I’m thinking about this here. But let me spell it out more granularly now.
Rates driving volatility
Interest rates are up globally, whether that’s in the Eurozone, Norway, Australia or wherever. That’s an outgrowth of the reflation trade that has driven risk assets higher in global markets ever since the US election ended and we got the first vaccine announcements. I look at the uptick in rates as a sign of optimism, first and foremost.
Recently though, the rise in rates has taken a more sinister turn because of inflation expectations. Real GDP growth is good. But nominal GDP growth driven as much by inflation as real GDP growth creates uncertainty. And that has roiled markets, particularly because the pace of the rate uptick has been so rapid. Last week people were starting to question when this rise in rates would end and whether it was worth holding onto these high beta assets given the risk of further moves higher.
Now, when I look at global interest rates, I look first to the US Treasury market given its size and importance. With the US 5-year down to 71 basis points today, and with stocks up sharply and Bitcoin up markedly off Sunday lows, it’s clear that global rates were driving risk asset volatility last week. The equity rally was stretched. And so a bond market selloff was a nice little trigger for equity selling too. But by Friday, the bond market selloff was overdone. And we met resistance around the 1.50% level on the 10-year. I am expecting less fireworks as we consolidate at these levels.
Framing forward-looking questions
So far so good for the near-term. But if we want to look forward, let’s get out our textbooks for a second here because the way I’m thinking about this depends heavily on my framework.
Central banks are monopolists in the issuance of base money. And they exercise this monopoly power by targeting the overnight rate for money. Any monopolist can only control either price or quantity, not both. And central banks want to target rates i.e. price. They can’t do that unless they supplies financial institutions with the reserves they desire to make loans at that rate. That means that the CBs must be committed to supplying as many reserves as banks want/need in accordance with the lending that they do subject to their capital constraints.
Markets know, therefore, that the major central banks, as monopolists, will always be able to hit their overnight target rates now and in the future. Therefore, this means that future expected overnight rates reflect only market-determined median expectations of future overnight target rates as set by the CB (plus a risk premium).
Long-term interest rates are a series of future short-term rates. All I need to do to mathematically represent any long-term interest rate is smash together a series of short-term interest-rates over the long-term period.
Think about this further out the curve. Five-year rates are interesting to consider here because they are far enough out the curve that current central bank policy shouldn’t ‘control’ price action. Market expectations have a bigger role there. But policy makers are keen to keep the rates range-bound. If those rates ever go up enough, it will draw a policy response. The question is:
- Will it be jawboning or actual policy moves?
- Will jawboning be enough (as it has been in the past)?
Central banks are comfortable with rates rising at a moderate pace consistent with reflation expectations. They are not comfortable with rates rising precipitously in ways that destabilize asset markets, the situation we saw last week. Were that to continue, we would see an increasing level of intervention from policy makers.
As I noted on the 25th, the ECB is already jawboning about watching long-term rates.The Reserve Bank of New Zealand has moved to action, doubling down on its stimulus pledge as forward guidance. And the Reserve Bank of Australia has already re-started bond purchases to hit target yields. So, we are already seeing central banks take measures. The questions are still the two above though: how far will they go and will it work.
Major central banks have an unlimited ability to create reserves. That’s a lot of firepower to manage rates. And while the whole bond vigilante framing of the situation makes punters feel good about putting government in its place, it has limited scope if the central banks set their mind and unlimited reserves to something.
I think of the currency as the release valve in all of this. The only reason interest rates rise in the currency area of a major interest-rate targeting central bank is because that central bank has raised policy rates — or investors expect it to do so. The real question is whether anything – say, inflation – would force the central bank to raise policy rates. Otherwise, the central bank can remain on zero or with negative rates indefinitely. And they can defend that stance with an unlimited creation of reserves.
So, in a nutshell, I don’t expect rates to shoot to the moon – not in Europe, not in the US, not in Australia. If they rose too far, too fast, central banks would do whatever it takes to halt the advance. And to the degree that makes their policy more accommodative than other central banks, the currency would weaken.
The threat is that rates go up enough over the short-term to cause undue damage. Central banks have telegraphed zero rates. And investors have shifted private portfolio preferences to higher-yielding and riskier asset classes. They are reaching for yield, greatly altering the pattern of capital investment in the economy. If yields rise enough before central banks intervene, you can get serious damage – a crash up in yields, followed by a crash down.
Because we’re in a gangbusters growth phase, the other threat is that growth crashes up and then crashes down. That move doesn’t have to be precipitated by rates either. It could simply be an outgrowth of demand that got pulled forward leaving a vacuum on the other side of the post-vaccine re-opening. Equity markets could start to move sideways and trend down in anticipation of above trend growth plummeting back to earth and overshooting to the downside.
So, I think the short-term looks good. But what happens toward the middle of the year when markets need to start thinking about the period after the post vaccine re-opening? I don’t know.
Bottom line: just because we are about to get a few huge GDP growth prints doesn’t mean all clear for risk assets. It’s all about what comes next. And on that, we still don’t know.
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