Hawks and doves are playing chicken on central bank decisions


For the markets, 2022 will be the year of the chicken game.

Inflation has accelerated over the past year, well beyond the tolerance levels of most central banks. So now is the time for policymakers to start withdrawing the stimulus measures that drove up asset prices after the first hit of the pandemic nearly two years ago.

Some central banks have already started removing the support they were injecting into the financial system. Among them is the Bank of England, which in December surprised investors with its first interest rate hike in three years.

And the most influential of them all – the US Federal Reserve – has started to scale back its asset purchases, while signaling that it will make three rate hikes in the course of the year. Investors increasingly believe that the first could arrive as early as March, and that three could be too conservative. The question is whether the Fed can do this without destabilizing financial markets.

Hence, the high-stakes nerve test. Corporate earnings and economic growth are of course important to fund managers, but the direction of interest rates is the dominant issue across all asset classes.

Policymakers ignored soaring inflation for almost a year. It is far from clear that they will now get tough and stick to their planned rate hikes if the markets get scared. Many investors doubt that policymakers have the courage to raise the cost of borrowing in the face of any spike in asset prices.

“Central banks cannot afford to be aggressive inflation fighters,” said Salman Ahmed, global head of macro at Fidelity. “It’s not compatible with economic stability because of the debt burden.”

The European Central Bank has particularly severe restrictions in this regard, given that its monetary support for the bond market is so crucial to maintaining the cohesion of the euro currency area. The Fed has more leeway due to the dollar’s central role as the world’s reserve currency, but even then “there is a risk of jeopardizing financial stability,” adds Ahmed.

Public debt in the United States was about 60% of national output in 2007, Ahmed notes. Today, partly because of massive fiscal largesse linked to the coronavirus pandemic, it is well over 100%, meaning that a huge chunk of projected GDP growth could be wiped out by interest rates. higher benchmarks that increase debt servicing costs.

The coronavirus has triggered a rise in US federal debt

“It’s the elephant in the room,” says Ahmed. “When inflation is below 2%, you can justify being dovish.” In the United States, it is now 7%, removing this option.

Already, cryptocurrencies and some of the more speculative areas of the stock markets have stumbled since the Fed showed more urgency in its shift to tougher policy, but the impact hasn’t rippled through markets. wider.

Some fund managers remain convinced that fiscal and monetary authorities can get out of this dilemma without further disrupting economic growth or markets.

Nevertheless, the last decade shows how delicate this process can be. In 2013, then-Fed Chairman Ben Bernanke sparked what became known as the “taper tantrum,” when he declared his intention to scale back regular asset purchases introduced after the 2008 global financial crisis. Currencies and emerging market bonds, in particular, fell sharply. cut.

On a smaller scale, in late 2018, current Chairman Jay Powell suggested the Fed was on “autopilot” toward steady rate hikes, triggering jerks in global equities. Within six weeks, he had changed his tone, calling for more patience. Investors viewed this as, at least in part, a capitulation to market pressures.

The same tension is present now. Raising rates too late or too timidly could turn out to be an act of self-sabotage that forces future generations to fight inflation and store up other long-term problems.

“For inflation not to become a problem, we need an abrupt tightening cycle,” says Luigi Speranza, chief global economist at French bank BNP Paribas. He thinks the Fed may have to raise rates faster than investors expect.

But acting too soon or aggressively threatens to strangle a global economic recovery already vulnerable to the vagaries of the pandemic and trigger a short-term market shock.

“The bear’s argument is that if we were to get a sharp increase in [benchmark bond yields], then everything from house prices to growth stocks goes down,” says Andrew Pease, global head of investment strategy at Russell Investments. Already, double-digit percentage declines in the value of some high-growth but low-profit U.S. tech stocks show just how biting those fears can be.

If policymakers repeatedly tighten liquidity and then pause, that will line up a year of “buying the dip” in markets, Pease says — a pattern already familiar, especially since the pandemic hit.

Falling interest rates and resilient demand for government bonds have driven yields down over the past four decades, increasing the appeal of riskier assets. Without a continued decline in bond yields, which many fund managers have grown accustomed to throughout their careers, these riskier assets could struggle.

Pease thinks a further drop in yields is hard to imagine, “unless you see a world where the Fed drives rates back to ECB levels, below zero.”

“Listen, it’s possible,” he adds. “But without that, it’s hard to see what the fundamentals are that are driving yields down even further. I don’t really see the rates going up, but I think we’ve hit the bottom of this cycle. Looks like it’s over.”

For investors and asset managers, this could make 2022 harder to navigate than the previous year and a half.


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