Central Bank ability to forecast is no better than anyone else's it seems, but history tells us to be wary of spiralling bond markets....

Wednesday 8th June 2016

Central Bank ability to forecast is no better than anyone else's it seems, but history tells us to be wary of spiralling bond markets....

ref :- "Time of greatest danger still lies ahead for bond investors" , INSIGHT by John Plender, The Financial Times, Markets and Investing

It's becoming a bit of a recurring theme ..... every time the Fed signals a policy move in the offing, something unexpected comes along to put the kibosh on their plans. Hopes that the next step on the way to the "normalisation" of rates, i.e. a hike,  was imminent were undone by last week's puny employment numbers, and it was only the latest in a series of disappointments that have undermined confidence in the link between the Fed's intentions and reality. Just a matter of days after Chairman Janet Yellen tells us that a hike would be appropriate in the next few months, possible dates in June and July are shot out of the water, and a move is not deemed more likely than not until December, according to futures markets at least.

These market predictions have not done the Fed any favours either, as they have consistently been less hawkish than most pronouncements from the central bank and generally speaking a lot more accurate. But one shouldn't single out the Fed for its shortcomings here, every central bank in the world is faced with the same issues  --  none have been significantly more successful in either predicting events or achieving stated aims, and some (Japan, for instance) have been trying and failing for a lot longer, decades even.

The fact is that even now no one is really sure how economies work in this post-crisis world of ours. And if you have little faith in longer economic projections, you tend to implement (monetary policy, that is) much more on an "ad hoc" basis .... thus we have come to hear so much about decisions being "data-dependent" . It's perfectly understandable of course, but is a prime example of policy being reactive rather than proactive and is a tacit admission that central banks are to some degree fumbling in the dark.

In fairness to central banks, it's not only what they don't know that is making life so difficult. What is plain to see is also a desperately difficult conundrum in itself. Short-term market gyrations aside, perhaps the most important of many basic problems facing policy-makers is the divergence between the economies of the US on the one hand, and of the Eurozone and Japan on the other. With the ECB and Japan still in record-breaking monetary-easing mode, the mere prospect of a Fed rate hike brings on a flight of capital from areas of negative return to the positive yields of US Treasuries.

The resulting dollar strength hits corporate earnings and therefore the stock market. Falling stock valuations have the effect of tightening monetary conditions, which puts back intended rate hikes and once again makes the Fed's forecasting record look even poorer. Even when the Fed does raise short-term rates , last December taught us that it has none of the desired effect on longer-dated Treasuries ..... they barely moved. In short, the Fed will struggle to "normalise" rates until stronger growth and inflation in the Eurozone and Japan bring an end to the easing process in those areas. 

So how does that leave investors ? As far as bond markets go, as so often it looks like a choice of going for higher-yielding riskier investments or plumping for safety even if it offers little, none or even negative yield. Even those sorts of instruments can make sense if you believe that yields can go yet lower, and therefore prices can go higher. But as Mr Plender points out in recalling two major debt crises from history which brought negative real rates to bond markets (and therefore soaring prices), the aftermath brought some

horrific reversals. The same won't be on the cards in the current situation until we see growth in the Eurozone and Japan, and until the Fed looks like being able to implement the more astringent policy it undoubtedly desires. But in these circumstances, who could confidently say that's a million miles away .....