/ 12 July 2013

Bitter battle to keep the markets calm

Bitter Battle To Keep The Markets Calm

For the next few weeks and months, Europe's central bankers will be arming themselves for yet another battle with the bond markets.

After a brief period of calm after the Spanish debt crisis last year, interrupted briefly by Cyprus flirting with bankruptcy, the bond markets are poised for a seismic jolt.

The situation is complicated —undemocratic you might say — as the world's largest pension funds and sovereign wealth funds vie with each other to maximise their returns, safe in the knowledge that only a few experts at the heart of the financial system have a clue about what they are doing.

One month they pile into, say, sovereign bonds, the next they turn to stock markets. Driven by fear and greed, they swim in the international money markets like sharks scenting a profitable kill.

Mark Carney, the Bank of England's governor, was being sniffed by the markets for a sign of weakness within hours of his arrival. Four days into his five-year tenure, he took the plunge into giving forward guidance to the markets.

The guidance said: "There will be no shocks. We intend to maintain ultra-low interest rates for some time", or words to that effect.

Promises
Mario Draghi, his counterpart at the European Central Bank, took the same step, promising an "extended period" of record low rates.

The problem faced by both bankers is that much of the bond market is focused on the United States, where some leading investors believe an end to ultra-low rates is inevitable sooner rather than later.

Some of the biggest investment funds that populate the bond markets are wrestling with the prospect of the Federal Reserve not only pushing up interest rates within a few years, but also bringing its $1-trillion a year bond-buying programme to a halt before the next northern summer. After years of feeding on cheap dollars, the party may be over.

And if the US pulls back, there could be negative effects on inflation, commodity prices and the real economy.

The Fed's quantitative easing (QE) spree, which is set at $85-billion a month, makes it one of the biggest bond buyers on the planet. Mostly, it buys US government bonds underwriting the Obama administration's growing debt pile.

Until a few months ago the only worry among bond investors was how the Fed's purchases pushed up the price of bonds left for sale. Higher demand for US treasuries sent returns spiralling down and encouraged investors to put funds into stock markets.

Recovery
The huge recovery in the FTSE 100 in the first half of the year can partly be attributed to a share-buying frenzy with money previously locked up in the bond market.

Such was the rise in the stock market that the Fed boss, Ben Bernanke, has hinted he might start to slow QE.

Pimco, one of the biggest bond fund managers, promptly experienced a huge outflow. Its boss, Bill Gross, wrote last week that panicky investors were blinded by the smoke from recent battles to the war's long-term outcome.

He pointed to the Fed's high tolerance of inflation. Just as the Bank of England has allowed inflation to yo-yo and peak at 5%, so the Fed is happy for its core inflation rate of about 1% to increase to beyond its 2% target, something Gross said would make inflation irrelevant as a guide to behaviour for many years.

Then he addressed the likelihood of a dramatic fall in unemployment to the 6.5% level Bernanke has targeted.

"Fed [0.25% interest rate] will not increase until at least mid-2015 and even then subject to a consistently strong economy that produces 2%+ inflation. I wonder if we can get there in this decade to tell you the truth," he said.

Gloomier
Far from endorsing the Fed, he is even gloomier, saying that short bursts of good news on the housing market or car buying belie the problems Western economies face from growing health and social care costs, competition from Asia that pushes wages down and a constant technological drive that is deskilling important white-collar industries from architecture to the media.

"The Fed is too cyclically oriented, focusing substantially on housing prices and car sales. And speaking of housing, since mortgage rates have risen by 1.5% in the last six months and the average monthly cheque for a new home buyer is up by 20% to 25% as well, then as I tweeted several weeks ago: 'Mr Chairman are you serious?'"

Growth will be negatively influenced, Gross added.

Carney faces a similar problem to Bernanke. He needs to convince the bond markets that a decent run of car sales and a booming housing market in the southeast of England do not make a surging economy.

And yet he won't want to sound so gloomy that he deters businesses from investing and consumers from spending.

There are many economists, mostly on the monetarist wing, who believe the underlying state of the economy is sound, and with the good times so close we need to calm things down with higher rates.

The answer
So every time Carney sounds modestly upbeat he will find himself stinging his audience with a bit of gloom.

Can he maintain this balancing act? As we have seen in the past few weeks, Bernanke only needed to allow the corners of his mouth to lift a little, to allow a slight smile, and the bond markets took flight.

The answer must be that central bankers can maintain their balance if they just keep recycling the same message for the next few years.

Fund managers will, no doubt, read too much into one speech against another and send demand rocketing, or the reverse, only for the status quo to reassert itself, which is great if you are a mortgage holder or have high debts. Low interest rates for longer are your saviour.

But the bond markets never lose. They will turn and seek returns elsewhere, sniffing weakness in developing countries or obscure stock markets.

These investments could turn into nasty bubbles and crashes, which leaves people — governments and small investors — getting hurt. — © Guardian News & Media 2013