On Thursday, in “The Hurdle Is Lower And The Risk Of A Central Bank Fuckup Is Higher – Sound Good?,” we said the following about the rapid rise in DM yields we’ve seen since Mario Draghi tipped the first domino in Sintra late last month:
To be sure, there’s something comical about the juxtaposition between this idea that DM central bankers are trying their best to “carefully” telegraph an exit from crisis-era policies and the hair-on-fire, mad dash to coordinate a hawkish message that we’ve witnessed since Draghi’s comments in Portugal on June 27.
As noted, they’re trying to micromanage this by the hour (that’s the “careful” telegraphing) but really, you need only look at a one-month chart of DM bond yields to see why it’s tempting to call this a rather ham-handed effort:
So far, that hasn’t translated into the kind of equity weakness you might imagine would accompany a “tantrum” but the jury is still out – remember, this has only been going on for three weeks. That is, try to extrapolate from that chart what yields are going to look like in a year if they don’t figure out how to get the messaging “right.”
The point there was simply to dispel this notion that just because rates are still low by historical standards, doesn’t mean what we’ve seen over the past three weeks hasn’t been dramatic.
The last bolded bit in the excerpted passages above is key. If this is what happened as a result of some jawboning and a rate hike from a central bank no one cares about (sorry Luke), then imagine what’s going to happen when the ECB starts unwinding and the Fed starts tapering the balance sheet. It’s a recipe for rolling tantrums.
Well, in a testament to the above, consider the following out Friday evening from Deutsche Bank’s Oleg Melentyev who notes “the limit is near” for policy normalization (also note that Melentyev underscores a point we’ve been pounding the table on for months – namely that credit refuses to respond to anything and has remained resilient throughout the rates mini-tantrum) …
Via Deutsche Bank
Credit spreads tightened over the past three weeks despite some notable rate volatility along the way. Overall HY spreads were 10bps tighter for the period, closing at 383bp, with ex-energy segment 9bps tighter and energy contributing the rest. IG market stood out during the period, in relative terms, having seen its OAS tighten by 7bp to 109. This happened in the environment of rising rates, which could be described as very strong in Europe, and moderate in the US. The 10yr German bund yield went up 35bps since June 23, touching on 60bps yield for the first time since Dec 2015. This increase is particularly impressive in percentage terms. In the US, the move in Treasury yields was more measured, with the 10yr going up by 20bps and 5yr by 15bps over the same interval.
The action in rates was underpinned by the change in rhetoric from the ECB in recent weeks, where the central bank appeared to have modified its view on the trajectory of its current stimulus measures. Specifically, President Draghi suggested in his verbal remarks that given the improved inflation backdrop and better visibility on the political landscape, a somewhat slower pace of QE could be judged as providing unchanged level of monetary stimulus in a sense of preserving negative real rates. It is unclear why these conclusions were not reached at the last scheduled meeting on June 8, but that is besides the point now. EU rates have reacted quite strongly, as even such a modest change in language makes a big difference in a world where investors have become accustomed to central bankers finding reasons to maintain stimulative policies. This episode provides a good example of just how difficult the eventual path to policy normalization is going to be.
The biggest risk on that path to normalization is a correlated unwind of monetary stimulus, or the exact opposite of the correlated wave of liquidity we witnessed since the financial crisis hit in 2008.
And while each of the major central banks has best intentions in mind in its quest to remove excess accommodation in the least disruptive way possible, it remains to be seen how well they can maintain a delicate balance while coordinating their actions across the world. In fact Chair Yellen was asked this specific question during her testimony in Senate, to which she gave the following answer: “we don’t coordinate, but consult regularly”. Whatever the language is used to describe their channels of communication, the market’s ability to adjust to a changing monetary policy environment is going to depend on how well each central bank takes the actions of the other into account in making its own policy decisions.
For the time being, we think the central banks are not going to be able to go too far on their paths to normalization.
Take a minute to let that sink in: the limit is near on policy normalization and they haven’t even started normalizing yet…