LONDON, March 15 (Reuters) – Central banks juggling inflation and financial stability mandates are prompting the wildest swings in bedrock government bonds for over a decade and a surge in volatility that may end up causing problems of its own.
With Federal Reserve and European Central Bank monetary officials in blackout periods ahead of critical policy meetings over the coming week, it was left to spooked and jumpy markets to work out on their own how much two sudden U.S. regional bank failures and a threat of contagion would affect those decisions.
The result was perhaps most predictable of all – a wild cacophony of views that saw some of the biggest one-day moves in two-year U.S. Treasury yields in decades and a spike in Treasury market volatility gauges to the highest since the aftermath of the last major banking crisis in 2009.
If banks being forced to mark bond values to prevailing market prices was part of last week’s problem, then bond markets behaving like penny stocks won’t help – not least in a year of other potential debt ceiling and geopolitical sideswipes.
And at the heart of the head fake is a potential conflict of central bank goals – expanded as they were for the Fed and other central banks after the Great Financial Crisis (GFC) of 2007-08 to include key roles in financial stability alongside the monetary policy pursuit of stable prices and maximum employment.
After helping organise the emergency depositor protections at the weekend, the overriding question this week is whether the Fed will now be too wary of destabilising the nervy banking system it just helped soothe with another interest rate rise next week – even if still punchy, above target inflation in the rest of the economy warrants it.
“The Fed and other central bankers have lost the luxury of focusing singularly on the fight against inflation,” said Manulife Investment Management’s Frances Donald. “Indeed, the costs associated with higher interest rates are rising.”
If the history of banking crashes and related credit crunches show them to be deflationary anyway, then many argue a central bank pause now may be the wisest choice.
And if the past week’s bank seizure is a first wave of lagged impacts from a year of brutal Fed rate hikes and related bond market losses, then to tighten the screw further at this moment may seem perverse.
And some of the debate about the systemic nature of the issue seems to be beside the point. The upshot doesn’t have to be globally systemic on a scale of the GFC to be extremely stressful and economically damaging.
If credit spreads and standards now tighten alongside banks’ cash hoarding – due to residual nerves across the banking sector even if not serial bank runs per se – then surely that will drag on the economy and inflation without further Fed overkill.
“The Fed needs to do less of the heavy lifting to get to the same outcome – tight financial conditions are slowing credit creation and will eventually slow inflation,” said Tiffany Wilding of PIMCO, one of the world’s largest bond fund managers.
“The question is not whether the Fed hikes 50 bps or 25 bps at the March meeting. Rather it’s, ‘is the Fed’s rate-hiking cycle over?’” For Wilding, “the frog may already have boiled.”
The flipside of that argument is that the second and third biggest U.S. bank failures ever were idiosyncratic one-offs that have been ringfenced by the weekend depositor rescues. No one though can be 100% confident of that yet in a U.S. ecosystem of some 4,000 banks, never mind equivalent European exposure after similarly rapid rate rises.
“The Fed is now fighting inflation as well as potential financial contagion,” Lombard Odier Chief Investment Officer Stéphane Monier said.
No wonder investors are finding it hard to agree a price for the basic cost of money.
At one extreme stage on Monday, money market and futures pricing had swung violently to remove virtually all expectations of further rate rises from the Fed, ECB and Bank of England – and priced up to a full percentage point of U.S. rate cuts by year-end.
Goldman Sachs rushed to say it saw no Fed hike at its policy meeting next week. Any thought of the half-percentage point hike that was being mulled by markets only a week ago has disappeared.
The first sign of regional bank stock calm on Tuesday, alongside the sticky core inflation readings for February, prompted a build-back of some bets for one last hike from each central bank. But the horizon for peak Fed, ECB and BoE rates has been dramatically lowered regardless.
The really scary action was in short-dated Treasuries.
From last Wednesday’s peak above 5% to early Tuesday’s trough, two-year U.S. Treasury yields dropped a mind-bending 125bps to 3.83%. They clocked the biggest one-day drop on Monday since the 1987 Wall Street stock crash, before rebounding almost 50 bps later on Tuesday in the biggest one-day jump since 2009.
While some of the dash to short Treasuries may well have been ‘safety’ flows related to nervy companies switching bank deposits to U.S. government securities, the gyrations are undoubtedly a reflection of uncertainty about the Fed dilemma.
And not only on policy rates – but on potentially confusing liquidity operations too.
“Central banks will now have to consider the impact of any further interest rate hikes on the stability of the financial system,” said Pictet Asset management’s Arun Sai, adding he now expects an earlier end to the Fed’s quantitative tightening because QT disproportionately impacts smaller banks.
The contradictions then abound. Much like the BoE’s hurried rescue of the gilt market last October after the botched UK government budget back then, the Fed may find itself in a situation of adding liquidity to the banks at one end of the stressed system alongside a QT drain at the other.
“Central bankers are in an increasingly tough spot,” said Carmignac’s Kevin Thozet. “It is quite the conundrum.”
The opinions expressed here are those of the author, a columnist for Reuters.