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Central banks to look through short-term volatility

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It has been a long-held view of the markets that central banks, in particular the Fed, would temper any monetary policy tightening when met with bouts of market volatility. This has typically been labelled the ‘Fed-Put’ and more recently rebranded the ‘Powell-Put’ given the expectation that the new Federal Reserve Chairman would continue the policies of his predecessors - including Yellen, Bernanke and Greenspan.

However, Powell appeared to have left this page of the modern central bank playbook at home when testifying to the House of Financial Service Committee. In a refreshingly direct testimony, he insisted the Fed would look through volatility and tighten monetary policy for as long as a strengthening economy allowed him to. He even went as far as to say that his outlook for the economy had strengthened since the December meeting despite the stock market turmoil that we have witnessed.

The significance of Powell’s testimony is that, after a decade in which interest rates have consistently undershot expectations, we could now see a period in which expectations are exceeded. The markets are increasingly adjusting to this, now pricing in a 70% chance of three rate increases in 2018 and a 30% chance of four rate increases.

So what does this mean for investors who are looking to manage their interest rate risk? Well, after a decade in which options, such as caps, have served borrowers well, more rigid strategies, such as swaps, increasingly have merit.

This is for two reasons. Firstly, when interest rates meet or exceed expectations a swap is most economical, as it doesn’t incur the cost of flexibility associated with an option. Secondly, as the timing of projected short-term rate increases has been brought forward we have seen a flattening of the yield curve, which has meant that the ‘cost-of-carry’ of a swap, the difference between the swap rate and the prevailing short-term interest rate (Libor), has narrowed. This is particularly evident in the US, which is further along the path to normalising rates, but a similar trend will likely follow in the UK and EU.

 

 

3 month [*]ibor

3 year swap 

5 year swap

10 year swap

20 year swap

GBP

0.58%

1.12%

1.28%

1.49%

1.60%

EUR

-0.33%

0.00%

0.36%

0.97%

1.46%

USD

2.02%

2.55%

2.66%

2.79%

2.89%


 

I would suggest that Powell hasn’t abandoned the Fed-Put but has instead re-evaluated the strike price which would trigger central bank involvement. Whilst the economy, both domestic and global, is doing relatively well, central bankers shouldn’t be distracted by volatility resulting from a steepening of short-term interest rate expectations. It is a necessary and short-lived evil on the path to normalising monetary policy. Instead the Fed should keep its powder dry given the unwinding of unprecedented monetary policy in the form of quantitative easing could potentially cause a systemic re-pricing in most asset classes as medium-long term interest rates increase.

Beyond the current rate hiking cycle, the yield curve is relatively flat, reflecting the markets’ confidence in central bank’s ability to control what is perceived to be modest inflationary pressure. Yet the markets are potentially oversimplifying the challenges facing central banks - most notably the impact of tapering their balance sheets over the coming few years.

If we take the US, which is most advanced in this process, it is the widely held belief of economists that the expansion of the Fed’s balance sheet resulted in a not insignificant 100bp cut in the 10 year treasury yield. Therefore, it is surprising that the markets seem to give little weight to the prospect that the reversal of such programs will result in upward pressure on government borrowing rates. In the US it might simply be that the current monthly program of $10bn is considered insignificant, however, the planned increase in the rate of tapering could result in a tantrum before the end of the year.

It would be short-sighted to see growing central bank confidence as simply a US phenomenon. The ECB and BoE are also keen to progress with the normalisation of monetary policy whilst benefiting from a period of synchronised global economic growth, so one should expect them to follow in the Fed’s footsteps. Proof of this will come on Thursday when Draghi is likely to follow on the coat tails of Powell’s bullish comments by withdrawing a commitment to increase the pace of asset purchases should market volatility dictate a need for this. However, the fallout of Sunday’s elections in Italy might soften manner in which he delivers this message. Those sceptical about Carney’s commitment to tighter monetary policy, which is understandable given previous false dawns, should not overlook the ending of the BoE’s Term Funding Scheme last week. The scheme had provided lenders with a cheap source of funding as interest rates approached zero and its removal will mean lenders will increasingly have to compete for deposits which is, in turn, likely to result in upward pressure on lending and interest rates.

Looking to the week ahead all eyes should be on February’s non-farm payroll figures (due Friday) in the US which have particularly importance following January’s impressive 2.9% figure. Another strong posting off the back of last week’s ISM manufacturing numbers, which showed prices rising at their fastest pace in seven years, may hint at growing inflationary pressure. Friday will also see a flurry of UK data which should show a pick-up in industrial output as well a narrowing of the trade deficit. In the Eurozone we have Q4 GDP data being released on Wednesday followed by the ECB meeting on Thursday, where the focus will be on the messaging rather than any actions.

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