The BIS, the central bank for central banks whose board is comprised of the worlds most powerful central bankers is out with its latest quarterly review.
As usual, the tome is preceded by remarks from Claudio Borio, Head of the Monetary and Economic Department and namesake of the fake Oreo.
Below, find Borio’s commentary on Trump and the market’s response to one of the most unexpected political developments in history:
It was looking like a quiet quarter, set to end as it had started. Then, once again, the calm was shaken by a political event that appeared to usher in a paradigm shift in markets. What happened in markets is just as important as why it happened. And the “what next?”, including its potential far-reaching impact, is not yet fully understood.
Let me start with the “what”. It was, once more, a surprising outcome to an electoral vote that triggered it all: markets, again, were completely wrong-footed. One is tempted to paraphrase Oscar Wilde: to get it wrong once may be regarded as a misfortune; to get it wrong twice looks like carelessness. Just as with the Brexit vote, markets had gone all-in ahead of the US presidential election on 8 November, only to have to cut their losses as events panned out quite differently from what they had anticipated.
Initially, the direction of market movements replicated what had been observed during the campaign as the two candidates’ chances of success waxed and waned. Within a couple of hours, the S&P futures plunged by 6%, Treasury yields dipped by almost 20 basis points, the dollar exchange rate (USDX basket) depreciated by 2%, and the price of gold soared by 5%.
But then, everything turned on a dime – the surprise within the surprise. For markets to do an abrupt U-turn, all it took was a conciliatory speech by the president-elect, the anticipation of larger budget deficits linked to tax cuts and some infrastructure spending, and the prospect of less regulation. The extent of the shift was remarkable. By the end of November, US equity markets had climbed to new peaks; US Treasury yields had risen by some 50 basis points, accelerating their gradual rise since the early-July trough; and, equally important, the trade weighted value of the dollar had increased by 4%, to a 14-year high (see graph). As a mirror image, the price of gold had dropped by 8%.
Naturally, events in the largest and deepest financial markets in the world, home to the dominant international currency, had major repercussions elsewhere. Sovereign yields rose in other jurisdictions and, within the euro area, spreads widened. Emerging market economies were especially hard hit, in ways partly reminiscent of the taper tantrum in mid-2013. In fact, exchange rate depreciations and outflows from dedicated bond and equity funds proved even larger than in that episode, although equity and credit markets reacted much less. Mexico suffered most, as the country most exposed to the risk of US trade protectionism and immigration curbs.
All along – and this is especially good news – markets functioned smoothly despite the price gyrations, not unlike what had happened at the time of the Brexit vote. This puts into perspective another event that had already interrupted the market calm during the quarter: the sterling flash crash on 7 October. In a matter of seconds, the currency lost no less than 9% vis-à-vis the dollar in thin Asian markets, only to retrace much of that loss subsequently. Still, just as with previous extraordinarily sharp but short-lived market moves, this one caused few ripples. We do not quite fully understand the cause of such unusual price moves, although no doubt ultra-fast large-volume automated strategies play an important role – one may legitimately wonder what the economic value of these strategies really is. But as long as such moves remain self-contained and do not threaten market functioning or the soundness of financial institutions, they are not a source of much concern: we may need to get used to them. More generally, the resilience of markets is a tribute to the efforts made to strengthen the capital and liquidity of financial institutions and to encourage better pricing of liquidity risk: stronger institutions make for more robust market liquidity.
So much for the “what”; what about the “why”? Developments during this quarter stand out for one reason: for once, central banks took a back seat. To be sure, financial markets had to work out how central banks would respond to the surprise developments: expectations of a policy rate hike by the Federal Reserve in December firmed, followed by additional, albeit historically gradual moves. Hence the upward adjustment in the path of expected short-term rates implicit in the yield curve and the rapidly narrowing gap between what markets expect and what the Fed projects. But it was not central bank utterances or policy decisions that, fundamentally, triggered the market moves. It is as if market participants, for once, had taken the lead in anticipating and charting the future, breaking free from their dependence on central banks’ every word and deed. In itself, this is healthy.
And so we come to the “what next?”. Are we facing a market overreaction or a paradigm shift? Hard to tell at this stage: the uncertainties involved are too large. What is surprising is that it took just one political event to seemingly dispel, in one fell swoop, the market’s belief in a future of persistently ultra-low interest rates, secularly low growth and disinflationary pressures. These events could finally represent the long-awaited beginning of a welcome normalisation process from the extraordinary post-crisis conditions. But the jury is still out, and caution is in order. And make no mistake: bond yields are still unusually low from a long-term perspective.