Parenthood and Central Banking
If capital markets can be likened to spoiled and obstreperous toddlers then the job of the central banker is to be the harassed parent. As a parent, you have to inculcate sufficient discipline while also making sure that the youngsters can stand on their own two feet and accepting that they will gain their liberty.
The next episode of difficult parenting is upon us. Bond yields have shot up (from very low levels) across the world so far this year. This reflects confidence that vaccines really will bring an end to the pandemic, whatever their teething problems, and there is plenty of pent-up demand to be released. Markets are looking for a parental response. Central banks have said they are going to leave rates lower for longer this time, but do they really mean it? If yields go up half a percentage point in short order (the monetary equivalent of threatening to scream until you are sick), will central banks relent at the risk of an even bigger tantrum next time, or opt to draw the disciplinary line, and put up with the screaming?
There have been two skirmishes between central bankers and markets already with another to come shortly as Federal Reserve Chairman, Jerome Powell, testifies to Congress. So far, it looks as though all of them will opt for giving the market what it wants, and risk spoiling the child.
Australia provided the first ‘parental’ test. Ten-year bond yields had rallied by 50 basis points in a matter of weeks, while three-year yields had risen above the 0.1% that the central bank had been targeting. The Reserve Bank of Australia (RBA) announced it was resuming bond-buying even though the economic news in Australia was good, with a successful record in containing the pandemic of late combining with a rally in commodity prices to improve the nation’s prospects. Australia, exposed to China and with a commodity-dominated economy, is a natural place to see the arguments over reflation play out first, and the incident was widely watched around the world. Initially, the RBA succeeded in bringing yields down, but they remain elevated compared to their target.
Next, the European Central Bank addressed the sharp rise in euro-zone bond yields. This may be an increase from a low position, but there is reason for caution. The euro area’s vaccine rollout has got off to a bad start, and much of the region needs stimulus. A jump in 10-year bond yields, even to a level of minus 0.3%, was enough to draw a response. The ECB told the European parliament they would maintain ‘favourable financing conditions’ throughout the pandemic period. As banks use those yields as a reference when setting the price of their loans to households and firms, the ECB will closely monitor the evolution of longer-term nominal bond yields.
These are anodyne comments as far as they go as all central banks need to keep an eye on long-term bond yields. However, they show the ECB is worried enough to resort to jawboning yields down when they were still comfortably negative, which is what the market wanted to hear.
It is now the Fed’s turn to try to find the right balance. The role of the Treasury market is particularly important. Sudden moves higher in yields, or in the dollar, have the capacity to mess up the emerging world. In the U.S., 10-year Treasury yields have rallied by some 50 basis points in less than two months leading to the widespread presumption that Powell will have to say something to pacify the markets when he talks to Congress. It is expected he will say the Fed is going to err on the side of caution until it is confident the pandemic is no longer having an effect on the economy.
Blessed by a swift vaccine rollout, the UK announced it would not return fully to normal until June at the earliest. That implies the U.S. is unlikely to be out of the woods until the end of the summer. The Fed has given itself little choice but to lean on the side of spoiling the toddler until then.
Perhaps most importantly, the stroppy toddlers that bother the Fed most are traders in equities, not bonds. The Fed wants to keep asset prices high and has shown no interest in intervening to pop the obvious froth appearing at the edge of the market. High stock prices owe much to low bond yields, and the governing fear for months has been of a spike in yields that brings equities down. For the time being, the stock market is treating the increase in yields as a symptom of an unambiguously positive global reflation.
What central bankers say will always matter to markets and there are still critical decisions to be made by those overseeing the vaccine rollout. Central bankers have to manage this part of the cycle very carefully, they have to deal with their toddlers with an even hand and must not be seen to favour or the other!
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