The thin line between complacency and clairvoyance

Blind, complacent, cool-headed, driven by moral hazard, clairvoyant? Or should we follow the example of the Bank for International Settlements and call it “dissonant”? Which term best describes this summer’s market behaviour?

The upturn in equity markets and falling interest rates on emerging market and corporate debt illustrate the search of investors for returns and, in doing so, their willingness to take more risk. Although economic and political uncertainties have not disappeared – far from it – they have done little to reduce risk taking. Liquidity created by the ECB and the Bank of Japan as part of their respective quantitative easing programmes have squeezed sovereign yields and pushed investors to invest in other asset classes, or simply to hold cash. The Bank of England’s decision to launch a new round of quantitative easing only strengthened this trend. Some will be tempted to blame “moral hazard”: when prospects deteriorate, the central banks rush to the rescue. This expression is too cynical though: Brexit has generated lots of uncertainty and raises fears of a negative impact in the short to medium-term, which justifies easing monetary policy.

Yet the repercussions can be felt well beyond the operational scope of these three central banks. The United States is also feeling the consequences, with long-term yields holding at very low levels. It is even tempting to say “too low” in the light of the US economic fundamentals. Growth prospects look promising in the second half of the year although some recent indicators showed softness in the manufacturing sector. Job creations are still going strong. Although employment figures reported in early September fell short of expectations, they were still solid. Employment was in the upper range necessary to maintain the current unemployment rate (between 75,000 and 150,000 new jobs per month). It is not surprising then that several Federal Reserve officials have tried – implicitly and with all the necessary nuances – to put a tightening move into perspective. This is where the word “complacent” seems to ring true: the markets underestimate Janet Yellen’s determination to raise the federal funds rate, if not on 21 September, than next December. Undoubtedly this is influenced by speeches of Fed officials who insist on the asymmetric pay-off of a tightening move: better to be a bit late and step up the pace of rate hikes later on than be too early and cause growth to plunge. In the latter case, the central bank would struggle to get the economy going again, as was implicitly acknowledged by Janet Yellen in her Jackson Hole speech last August. This would imply that “clairvoyant” also seems to be just as pertinent: investors understand that the cumulative tightening phase during the current cycle will be relatively mild. In other words, everything possible will be done to avoid turmoil in the US bond market.

In the past, bond market shocks have had major repercussions on the equity market, the dollar, currencies and the emerging economies. The prospect of a world without turmoil arising from the US justifies greater risk taking. Yet such a strategy would also imply greater exposure to other sources of volatility, such as political uncertainty (US election results, for example) or the Chinese economy, where the slowdown continues, although August data have brought welcome relief. Lastly, US inflation could finally rear its head and accelerate strongly, which would take everyone by surprise, forcing the Fed to step up the pace of tightening. According to Fed officials, the market reaction to a more aggressive Federal Open Market Committee would all in all be limited. That remains to be seen however.

William De Vijlder

Group Chief Economist, BNP Paribas

20 September 2016