A CROWDED, CLUSTERED AND POTENTIALLY VERY DISRUPTIVE BET ON CENTRAL BANKS / THE WALL STREET JOURNAL

A Crowded, Clustered and Potentially Very Disruptive Bet on Central Banks

An explanation for the clustering of future rate expectations is the power of central bank guidance

By Richard Barley


CLUSTERED
U.S. interest rates implied by swap markets

Clear guidance about future policy has become a powerful tool for the world’s central banks. It has delivered lower market volatility, and kept financial conditions easy. But that may simply be at the cost of deferring market disruption for another day.

One startling way to see this is to look at expectations of short-dated interest rates in the future, such as rates derived from the swap market. These should represent an attempt to look beyond the current conditions that have caused bonds to stick in narrow ranges and the yield curve to flatten: skepticism about growth today and the ability of central banks to generate meaningful inflation.

Expected future U.S. interest rates on this measure have converged to a narrow range between 2.5% and 3%, data from Société Générale ’s foreign-exchange strategists shows. That’s another sign investors see little chance the U.S. will depart from the gentle, limited path of interest-rate rises it has set out on, perhaps in response to rising inflation.

An explanation for the clustering of future rate expectations is the power of central bank guidance. Ever since the Fed sparked the so-called taper tantrum of 2013, central bankers have been at pains to avoid surprising markets. As the taper tantrum hit, for instance, the one-year rate in 10 years’ time rose to over 5%, even with the Fed-funds rate still close to zero; it was around 3 percentage points higher than the one-year rate in two years’ time.

The Federal Reserve in Washington. Photo: Pablo Martinez Monsivais/Associated Press 


One means of achieving that calm has been to signal clearly what the likely path of policy is: in the Fed’s case, the famed dot plot suggests rates will rise only gradually and rest in the longer run around 2.8%, far below previous interest-rate peaks. That has been accompanied by plenty of rhetoric from central bankers suggesting that the underlying equilibrium interest rate has declined too.

The problem comes if either the market or the Fed decides that this picture of the future is no longer valid. Given how close together expectations of various points in the future have grown, a repricing could be sharp and disruptive. The same risk perhaps applies even more to other central banks where guidance about future actions has become a key part of the message, but where policy settings remain ultraloose, like the European Central Bank. So far communication about the direction of policy has been smooth, but it may not stay that way.

The early days of 2018 are already hinting at a bumpier ride for bonds as global growth remains robust. A debate is getting under way about how and when the ECB might begin to shift its guidance on policy; nerves about the same issue in Japan have also emerged. Chinese monetary policy is another wild card to watch. The starting gun for a bigger move in fixed-income markets hasn’t gone off. But investors should worry when the trigger gets pulled.