The bonds sell-off that began when the Federal Reserve signalled it would soon wind down its emergency asset-buying has become known in markets as the “taper tantrum”. We might now be in a new phase: the “hike huff”.
Investors’ focus is starting to shift beyond the end of “quantitative easing” and on to the question of how soon central banks will start to increase short-term interest rates.
Some of the most dramatic reaction to Friday’s disappointing US jobs report was in shorter-term rates.
If policy setters get it right, they will normalise rates only when, and only because, their economies are finally strong enough to stand on their own. However, there are worrying signs that central bankers’ ability to control rate expectations are breaking down, just as they put more and more faith in the power of their “forward guidance”.
Even after sliding from 50 basis points to 45 basis points in the immediate aftermath of the payrolls data, the yield on the two-year US Treasury has more than doubled since early May. That signals that markets believe US rate hikes will have begun less than two years from now, perhaps as early as next year, despite the promises of the Fed.
“It is this unanchoring of the front end of the yield curve that makes the latest sell-off different in flavour from what we saw in the previous couple of months,” says Zach Pandl, senior interest rate strategist at Columbia Management.
“Markets realise that you have a lame duck Fed chairman, and forward guidance, so important for anchoring short-term rates, was put in place by Ben Bernanke and Janet Yellen, who look like being succeeded by someone from outside who may have a different view of their commitment to keeping rates low.”
Mr Pandl is referring to Washington insiders’ growing belief that Larry Summers, former Treasury secretary, is President Barack Obama’s favoured pick to run the Fed when Mr Bernanke steps down in January.
But while that creates special uncertainty over US monetary policy, the declining faith in forward guidance is being seen elsewhere, too.
Investors have brought forward noticeably the expected timing of central bank interest rate hikes in Europe, despite attempts by the European Central Bank and Bank of England to use guidance to keep the lid on short-term borrowing costs. Mario Draghi, ECB president, also expressed extreme caution on the strength of the eurozone recovery.
Markets expect the BoE to raise interest rates at the end of next year, and the ECB roughly six months later, although signals being sent by markets on the timing of ECB interest rate moves are being muddied by the large amounts of liquidity eurozone banks are repaying to the central bank.
The reappraisal followed strong European purchasing managers’ indices this week, especially in the UK. There had also been a run of stronger data in the US, until Friday, although the run-up in short rates began even while the data remained mixed.
If, at the same time as ending QE, central bankers lose their ability to suppress short-term rates, there could be consequences for bank profitability and the availability of credit in the economy, for investment and for growth, and for all investors who use short-term leverage to juice their returns from long-term assets.
On many people’s minds is the bond market carnage of 1994, when short-term borrowing costs soared, leveraged hedge funds collapsed and banks plunged into the red.
There are plenty of voices arguing that the markets are getting both the timing and the speed of future rate hikes wrong.
Anton Heese, co-head of European rates strategy at Morgan Stanley, says: “Many of the central bankers we have now are former academics who have studied depressions. The pace of tightening is going to be a lot slower. A repeat of the 1994 scenario is unlikely.”
Mr Pandl says the biggest single impact from higher short-term market rates is to lift borrowing costs across the spectrum. The 10-year US Treasury touched 3 per cent for the first time in two years this week, pushing the rate on a new fixed rate mortgage in the US to a new two-year high, according to Bankrate.com, with potential effects on the housing market.
Citi on Thursday published a study showing how changes in long-term borrowing costs in the US create similar effects in other country’s interest rates, suggesting the “hike huff” could become a global phenomenon.
“Macro developments in the United States (including changes in monetary policy) seem to influence inflation and growth prospects in the euro area and the United Kingdom, which in turn elicit policy responses from their central banks,” wrote Citi economist Nathan Sheets.
Ken Fisher, chief executive of Fisher Investments, calls Mr Bernanke “a boxer ahead on points after 13 rounds”. He says: “If I were him, I would play not to lose, and that is what he is doing. He is very methodical. After he is gone, nobody knows what happens then.”