Sunday, February 11, 2018
Be braced for a bumpy ride back to normal
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

The economic story of the week was the Bank of England’s “hawkish” signal that interest rates could rise “somewhat earlier and to a somewhat greater extent” than it expected three months ago. The financial story of the week was the record 1,175 point fall in the Dow Jones on Monday. It wasn’t a Black Monday, but it was pretty grey.

It was followed by wobbly Thursday, another 1,000 point fall, before a small recovery on Friday.

My task today is to draw these two things together, and it is not as hard as it sounds.

In normal times the Bank’s more hawkish stance on interest rates would be looked at through the spectrum of what Mark Carney, the governor, described as “the shallowest investment recovery in more than half a century”.

Housing market activity remains very soggy, as described here last week. And, while the Bank offered hope that the squeeze on real incomes will ease this year, thanks to bigger pay rises and falling inflation, we are not there yet. Normally these would not be the conditions in which the Bank would contemplate rate hikes, with the smart money on May.

These are, of course, not normal times. A stronger world economy has provided for a modest upgrade of the Bank’s growth forecasts, although they remain notably weaker than it was expecting two years ago. But the economy’s capacity to grow has also suffered, thanks to low investment and weak productivity. Growth of 1.75% a year compared with a speed limit of 1.5%, means more “limited and gradual” rate rises. We wait to see whether the Bank delivers on its hints.

Part of what the Bank is embarked upon is what is known in the jargon as normalisation. Monetary policy has been abnormally loose, and the aim is to return policy to something a little more normal. That may only mean 2% or 2.5% official interest rates in Britain, in time, but it is higher than the near –zero rates that have prevailed for the past decade.

There is, however, a bigger story here, and it takes us back to that plunge on Wall Street. Part of the normalisation will be achieved through higher interest rates, but part of it comes through reversing quantitative easing (QE), the assets purchased with electronically created money that central banks employed to prop up crisis-hit economies.

The great QE experiment is coming to an end. In America, the Federal Reserve is running down its QE holdings by the simple expedient of not reinvesting the proceeds of the maturing bonds it has on its books. Barring a disastrous cliff-edge Brexit, we are unlikely to see any more QE from the Bank. The European Central Bank will wind down its monthly QE purchases to zero this year.

Something else is happening. In the period since the financial crisis, bond markets have not only benefited from central bank purchases under QE, which has soaked up the supply of government bonds, but they have also gained as a result of tight fiscal policy. Governments have, in the main, acted to reduce the big budget deficits established during the crisis.

Mostly, though it continues for a while in Britain, that process has also come to an end. It has come to an end spectacularly in America, where official projections are for a $955bn (£680bn) budget deficit this fiscal year, up from $519bn in 2017. $1 trillion-plus budget deficits will soon become the norm in America. The Trump tax cuts may have helped invigorate the economy but they are expensive.

Austerity has come to an end too, on an aggregate basis, in the eurozone, where it was arguably most painful. It is one reason for the eurozone’s strong economic bounce.

The consequences of this, on a simple supply and demand basis, look to be quite straightforward. There will be a bigger supply of government bonds and, without central banks to soak them up, the price of those bonds will fall and the yields on them rise. This is not the bursting of a bond bubble but simple arithmetic.

In the case of America, the extra supply that the markets will have to absorb is the near $1 trillion budget deficit plus roughly $450bn of bonds that the Fed would have soaked up by reinvesting but will no longer do so. It is one reason why the 10-year US government bond yield has been nudging up towards 3% and it is reflected in similar if smaller moves elsewhere.

Why does this matter, and what does it have to do with the Dow’s plunge? Low bond yields have supported high stock market valuations. But when the spread between government bond yields and riskier equity market yields narrows too much, there is only one way for the stock market to go, and it is not up.

This, as I say, is entirely logical, if painful for some. The real problem would come if markets also start to seriously think that a significant rise in inflation is on the way. That fear, sparked by a stronger than expected reading for pay rises in America, would translate into an expectation of even faster rises in interest rates.

The International Monetary Fund warned of something like this in its updated world economic outlook last month. “Rich asset valuations and very compressed term premiums raise the possibility of a financial market correction, which could dampen growth and confidence,” it warned.” A possible trigger is a faster-than-expected increase in advanced economy core inflation and interest rates as demand accelerates.”

This is not the situation we are in yet. Give the strength of the world economy, inflationary pressures remain subdued. But even in the context of that strength, stock markets got ahead of themselves. For some, the return of volatility is no bad thing, reminding everybody that there are risks as well as opportunities.

But the return of volatility is also a useful reminder that the return to normality, when it comes to monetary policy, could be quite a bumpy ride for investors. Whether it gets too bumpy for central banks will be one of the interesting things to watch.