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Morgan Stanley bank analyst Huw Van Steenis attended the World Economic Forum in Davos last week, and there was one concern he said kept coming up over and over in meetings with investors.The dreaded “1994 scenario.”
In 1994, against the backdrop of a strengthening U.S. economy, the Federal Reserve surprised investors by hiking interest rates, causing a bloodbath in the bond market. The Fed was trying to ward off inflation – even though no real sign of rising prices had yet emerged.
Van Steenis says this concern was voiced by “every single long-term asset owner” that he met.
In a note to clients today titled “What I Learned at Davos,” Van Steenis writes:
The consensus of much of the official sector and investors at Davos was that central banks have maxed out and should be soon start focusing on exit, given the unprecedented size of this experiment and its impact on asset prices.
Every single long-term asset owner I met, and numerous longer-term investors, voiced concern about asset prices and the risks from a huge knock from rates backing up (a super-sized version of 1994). While so far one can argue that the monetary injection was vital to offset massive deleveraging, it is clear that the risks for debasement of currencies remain high.
However, the vibes Van Steenis picked up from policymakers painted a decidedly different picture.
Van Steenis continues (emphasis added):
One of the most debated topics in the corridors of Davos was the dramatic changes in Japan, with the new government keen to jumpstart the economy with a new 2% inflation target which has led to a material depreciation in the Yen.
And yet several central bankers argued there is more they can do. In one public debate, Angel Gurria of the OECD argued that the world had probably reached the limits of monetary policy. But Mark Carney contradicted Mr. Gurria saying “There continues to be monetary policy options in all major economies and they have to be framed in the context of the [monetary policy] mandate.” This flexibility should be used until their economies reach “escape velocity”.
While Mr. Carney was speaking at a generic level for all central banks, I came away from this debate and other meetings with central bankers that that this quantitative experiment is far from over. Not only in Japan are we seeing a bold new experiment but that the new Bank of England governor is likely to give it an extra nudge with a de facto or de jure change in mandate. My colleague Charles Goodhart wrote about options on this early in January. What does it mean for UK banks – in the longer term a stronger economic recovery is a clear positive; however, the market may underestimate that the normalisation in rates and margins may take longer to come through.
In other words, though it’s the biggest fear on everyone’s mind right now, a “1994 moment” may be kept at bay longer than most expect as central bankers continue to experiment with monetary policy in a bid to spur growth.
Of course, that doesn’t mean that those experiments can’t backfire – but so far, at least with regard to interest rates, they haven’t.
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