Market action over the first part of the past week appeared
to make sense – the second half left market participants wonder whether they
had collectively gone slightly schizophrenic. First equity markets in Europe
and the US rallied to new highs as economic data and central bank statements
appeared to create the Goldilocks environment of ‘not too warm, not too cold’,
stock markets like so much. In Europe equity markets seemed to ‘salivate’ over
the prospect that the ever falling rate of inflation will force the ECB to
finally launch its own program of quantitative easing (QE) - aka - printing
money. Then on Thursday and after the Bank of England’s governor Mark Carney
had talked down exceptionally good UK data they appeared to realise that
monetary easing actually is a consequence of things not being quite alright.
Stock markets fell quite abruptly by up to 2% and even more extraordinary,
longer maturity bond yields fell back sharply. This bond rally (yield and bond
values move inversely) was even more astonishing as most market participants
have for a while now expected a break out from the recent tight trading range,
but on the downside, not the up! On Friday stock markets came back to their
senses and recovered somewhat, however, 10 year gilt and treasury yields have
stubbornly remained at around the 2.5%.
It
seems nonsensical that bond investors should be willing to accept less return
for their locked-up money, when the economy is expanding and therefore better
return alternatives are available and inflation eventually rises and eats away at
the purchasing power of bond values. So what has happened? The simple answer
is: The central banks got their way but market participants can’t quite explain
why.
When longer maturity bond yields almost doubled last
year on better economic prospects, central bankers were not best pleased,
because markets were undoing their QE efforts of keeping not just short term
rates, but also the longer term cost of capital low. This was to absolutely
make sure that both the credit markets and the wider economy can sustainably recover.
It seems that only over the past few months markets have come to actually
believe central bankers’ assurances from last year that this time they will
keep rates low for longer. Various reasons were banded around this week trying
to explain why yields were falling when things actually look up a lot more. My
humble opinion is simply that amidst last year’s euphoria over the economic
recovery, bond yields overshot and what we have seen now is a re-adjustment
towards a more gradual incline, as would have made sense all along. I therefore
strongly disagree with those who (once again) interpret this temporary
countertrend movement as heralding the end of this economic cycle. I expect
that a more measured and gradual rise in yields will resume fairly soon. There
is a positive here which too many market commentators have failed to mention,
which is that low cost of finance is supportive for economic growth. Last
week’s disappointing GDP and industrial output growth figures in the Eurozone serve
as timely reminders that there is still not much reason to get carried away and
to expect cyclical overheating symptoms any time soon. The gradual
normalisation process is to some degree unchartered territory, because central
banks have never before been as determined to see the economy and the financial
sector heal, before withdrawing their support. This causes unintended side
effects, the UK house price inflation pressures being one of them. However, we
must not confuse cause and effect here. A house price rally in the past may
have been experienced as a late cycle occurrence, which this time around is
very unlikely to be the case. As such expect the UK’s Bank of England to
unleash their arsenal of macro-prudential defence instruments instead of early
rate rises, once they come to the conclusion that further price rises (beyond
London) are posing a risk to our future prospects. Lower loan to value and/or
mortgage to income ratios enforced through the banks will prove very potent
means of calming things down. I now don’t expect the first UK rate rise before the
general election in 2015.
Read more at: www.kassiusannuities.co.uk
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