- Financial market volatility — especially in stocks — has increased in recent weeks following a lift global bond yields.
- Deutsche Bank says bond yields will continue to rise creating “a more complicated macro environment” for investors.
- If central banks react to increased volatility by keeping monetary policy settings excessively loose, Deutsche says this could risk even greater instability in the future.
After years of low financial market volatility, steadily improving economic data and predictability in central bank policy moves, the world is starting to look a whole lot different in early 2018.
While, on the most part, economic data continues to impress, markets have clearly adopted the view that the era of ultra-loose monetary policy settings is coming to an end.
The economy has been picking up speed for several years, and has become more synchronised in nature, helping to eat up spare capacity in labour markets leading to the prospect of faster inflation arriving in the future.
Bond yields have spiked as has volatility, especially in stocks.
No longer is the discussion about when central banks will deliver additional monetary policy stimulus, but rather when they’ll take it away, or how fast.
And, beyond that, how will financial markets react when they do.
Given the trends seen over the past few months, it’s clear that bond markets will have a large say as to how it will all play out.
After initially viewing rising yields as a positive sign that the global economy is reflating, investors are now viewing the lift in yield negatively, potentially weighing on economic growth and asset valuations as a consequence.
To Deutsche Bank’s strategy team, financial markets have now entered a “delicate point” in the post-GFC era, noting in a recent research report that a “more complicated macro environment lies ahead”.
It sees bond yields continuing to rise in the years ahead, a scenario that it says will not be without its risks.
“We think rates and yields will continue to structurally move higher in the quarters and years ahead regardless of any short-term moves [from central banks],” Deutsche says.
“An era of higher rates and yields won’t be without risks and will bring higher volatility and more regular risk selloffs.”
Specifically, Deutsche says a combination of stronger economic growth, increased fiscal spending in the United States and stronger supply of US government bonds on issue will act to push yields higher.
“In 2018 inflation is back due to usual lag between growth and inflation and the fact that post-GFC output gaps now closed. Lessons from the late 1960s’ spike in inflation, after US unemployment hit 4% and the US budget deficit expanded, should be heeded,” it says.
“Government supply is also back in 2018 with the expanding US budget deficit.”
It also points to reduced asset purchases from the ECB and the Bank of Japan following its switch to targeting the shape of the Japanese yield curve rather than nominal asset purchases as other factors that should underpin yields globally.
As for the risks to its view, Deutsche says they largely come down to how financial markets will react to higher borrowing costs.
“The biggest risk to the view is that the financial system is now so rate sensitive that rates/yields/inflation rising causes a sharp tightening of financial conditions which feeds back into much weaker growth,” it says.
“This may cause central banks to pause tightening and even move back to an easing bias, which would likely be more supportive for fixed income.
Essentially, with global debt levels at record highs, th financial system will struggle to handle higher rates and yields.
However, even if volatility does increase and asset prices fall, Deutsche says should central banks act to address this by keeping rates and yields low, it will risk seeing asset bubbles form, potentially creating even more financial instability in the future.
“Ultra-low volatility in 2017 was in large part a central bank creation and has risked ‘Minsky moments’,” Deutsche says, referring to a scenario where asset prices fall heavily following a period of excessive risk-taking and strong asset price growth.
“The recent volatility shock is evidence that policy being too loose for too long can be destabilising when the environment changes.”