October 31, 2016    6 minute read

Central Bank Tantrums

The Game Changers    October 31, 2016    6 minute read

Central Bank Tantrums

The word “taper” was first used in May 2013 when the former US Federal Reserve Chairman Ben Bernanke announced the beginning of a reduction in purchases of US bonds. The title for the volatile market moves was “taper tantrum” as the announcement caused mass ripples across global financial markets.

The impact is especially hard for emerging markets as they had accumulated significant amounts of debt in dollars and the taper meant an unwind of large carry trade positions. The carry trade was popular post crises as US rates were at zero, relatively small in comparison to the high-yielding emerging markets. Couple that with a stable strengthening dollar and you had a perfect carry trade.

The severity of the tantrum was particularly pronounced in the emerging market currencies with the South African Rand depreciating 89% over 22 months.  For the developed, liquid, markets, US 10yr yields spiked from 2% to 3% in four months and the closely tracked US Equity Index, S&P 500 fell 6% over a four-week period.

USDZAR

(USDZAR; Source: Reuters)

spx and tnote

(Central range, S&P500 equity Index, Purple: US 10yr Note yields; Source: Reuters)

It is important to understand the implications of central banks tapering because across the developed world the US Federal Reserve is the only central bank to have tapered. One day, in the not too distant future, one will see similar policy unwinds from the likes of the European Central Bank (ECB), the Bank of England (BoE), the Bank of Japan (BOJ) and many others. However, this time around the implications for the markets will be notably different. This is why:

To understand the financial environment over the past eight years, you need only look at the policies of global central banks. The 2008 crises handed full control of economies over to respective central banks as fiscal policies took a step back. The logic was to fix interest rates at unprecedented, historically low levels to encourage the private sector to invest, spend and drive recovery cycle. In theory, this should have worked well. In practice, there has been modest recovery, as the private sector has spent the last few years repairing balance sheets, deleveraging, swapping equity debt for cheaper bond debt, cutting costs and improving inefficiencies. The recovery should have taken hold far sooner than it did.

The underlying problem was that the crisis of 2008 led to a global slowdown in demand, which meant it was not only the US Federal Reserve to embark on a massive stimulus package. Other central banks were forced to follow one by one. Central banks globally began slashing rates toward their respective lower bounds. When that did not have desired effect to stimulate demand and inflation, they embarked on large-scale bonds purchases to effectively peg long end rates at historically low levels to encourage investment and spending.

The result of excessive central bank bond buying was a new policy called, negative interest rates. A principle not listed in many economics textbooks, but one that is being utilised by a handful of the large central banks. Economic history is being made while this article is written. So why should you be aware of this historic moment?

Ceteris Paribus

All things being equal – equilibrium will and must be restored. This will not look pretty as we have been in extreme disequilibrium for almost a decade. The primary concern this time around is when the other central banks hit the “taper” button. It will be simultaneous. What guarded the world back in 2013, 2014 and 2015 is that while the Federal Reserve was unwinding, the ECB, BOJ, SNB, Swedish Central banks, RBA, RBNZ were all cutting rates further and embarking on their bond purchase programmes. The mantra “don’t fight the central banks” has proven itself time and time again to be the right strategy.

But what happens when there is no other central bank that is buying bonds? This time, with policy stimulus being tapered across the globe, which one will save the day? Who will take the other side of the trade? When you attempt to answer these fundamental questions, you will quickly realise how different this time around will be. The odds of an implosion in rates and a global sell-off in equities are high.

What Will Be The Trigger?

The trigger, while disguised, was initiated by the BOJ in early October. Titled “yield curve control,” the BOJ’ Kuroda has told markets he would not be surprised to see higher rates and they are comfortable with this. More importantly, the BOJ has signalled to the market they are no longer willing to buy at a fixed rate as the influence on market dynamics is too influential, but also there simply is not enough supply for them to buy a fixed allotment.

The BOJ has finally realised that low rates do not imply demand and subsequent inflation. They have now resorted to a new measure. This measure is to allow some steepness in the longer dated rates curve, and a gamble on this will prompt investors to bring future spending forward to take advantage of lower rates today. If it works, inflation will be the result and market participants will finally begin to bet on the return of inflation and growth. This trigger has gone largely unnoticed. But there are murmurs and whispers amongst market participants of the return of inflation.

The second trigger could come as soon as 8 December 2016 when the ECB meets. All institutions, expect the ECB, continue to buy bonds well beyond the current March 2017 expiry. Where participants disagree is on the size of the monthly purchases. Any change to the current 80bn monthly purchases and this will confirm that another major tantrum is looming. One would argue the tantrum has begun and that the second trigger will merely exacerbate these moves.

global bond yields

(Blue, German 10yr Bund. Green, UK 10yr Gilts, Orange, US 10yr Notes; Source: Reuters)

One needs only look at the European Bonds yields, German Bunds and UK Gilts to see the beginning of something big. For most of 2016 investors have remained complacent and sidelined. With endless central bank support, there is only one effective strategy in town. This time around the wise voice in my head tells me: “best brace for the fallout”. It is time to prepare for the “taper tantrum,” version 2.0.

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