Of course central bankers’ decisions have, at least superficially, been supported by their often one- dimensional mandate to target inflation. While many of their targeted measures have been below their objective, inflation has been showing up in other areas, most notably housing and financial assets. Looking at the bigger picture appears to be something that some central bankers are better at than others. Instead of recognising that interest rates may be at the wrong level, policy makers have sought to tackle the symptoms rather than the cause.
Similarly, ‘forward guidance’ has focused on unemployment rates and the goal posts have constantly been shifted. For example, two years ago the Federal Reserve’s best estimate of full employment was between 5.2% and 5.6%. However as unemployment continued to trend lower, with few signs of wage pressures, these estimates were continually reduced. We have some sympathy with the idea that full employment is not observable but, if we wait until wage growth is rising meaningfully, it is invariably too late to raise rates in a gradual way that will prolong the economic cycle.
As the cyclical recovery has become more apparent, investors have started to prepare. They have, in many cases, reduced interest rate exposure and started to adjust investments to reflect a world where deflationary risks have subsided. Yet, time and again central banks have continued to behave as though deflation remains the primary threat and emergency measures are still required. Such actions have meant that investors positioning for a reduction in policy accommodation have often found themselves on the wrong side of market moves. In short, the improving economic fundamentals have not been driving markets.
The secular deflation camp has recently gone quiet and there is growing evidence that the economic cycle endures. Policy makers, rarely the quickest to react when it comes to removing the punch bowl, are also paying attention. There is a growing acknowledgment that the costs of current super-easy monetary policy are beginning to outweigh the benefits. Growth in the US and most of Europe is now running above trend and inflation is at or close to target. As an added benefit, growth within the major regions is also looking increasingly synchronised.
There is only so long that continued improvements in the fundamentals can occur before even the most dovish of central bankers needs to respond. Over the past two years we have been noting these improvements but ever more negative interest rates, in the eurozone and elsewhere, have been pushing markets away from equilibrium. In a number of cases, valuations have become extremely stretched. We believe that the pieces are falling into place for a more notable shift away from the post GFC policies, allowing fundamentals to reassert as the primary driver of asset-price movements. In many cases, markets are still priced for a continuation of ultra-accommodative monetary policy and this appears to have created some very attractive and asymmetric trading opportunities, especially for discretionary macro investors.