By Mike Dolan
LONDON (Reuters) – Having inflated balance sheets once again to keep a lid on long-term borrowing costs during the pandemic, central banks now face a conundrum over how to keep the steep rise in government and company debt affordable as markets anticipate the recovery.
How they manage this next stage of the crisis will define the future relationship between operationally independent central banks and governments — a line often blurred over the past decade but which many feel could now dissolve completely.
A slight backup in Treasury yields over the past week puts Wednesday’s Federal Reserve meeting in sharp focus, adding pressure on the U.S. central bank to challenge the move in some way, either with guidance or action.
Many central banks have already taken policy rates to zero or negative and seem reluctant to move further, leaving the emphasis on buying ever more bonds to keep long-term debt costs down, known as ‘yield curve control’.
And for many, the die is already cast.
“We are in a ‘soft’ Modern Monetary Theory-inspired policy regime,” said Pictet Wealth Management economist Thomas Costerg, referring to the much-debated view that central banks can and should support government investment spending by capping interest rates in the absence of inflation.
“Hyperinflation will only be a risk if the Fed moves to ‘pure’ MMT — which would include the Fed being placed under the White House’s direct control — but we see this as unlikely.”
Markets are assuming the G4 central banks from the United States, euro zone, Japan and Britain will expand their balance sheets by more than $12 trillion, or about 30% of collective gross domestic product, by the end of next year.
Yet just a whiff of recovery, strengthened by signs of a turn in the U.S. jobs market last month, saw 10-year Treasury yields add 30 basis points in a week, to as high as 0.95% before steadying. Market optimism also caused the yield gap between two-year and 10-year Treasuries to jump 20 basis points.
(GRAPHIC: Central banks face big test – https://fingfx.thomsonreuters.com/gfx/mkt/qmyvmoymmvr/cenbanks.PNG)
STOCKS NOW RELY ON NEW REGIME
Many economies have yet to recover even 50% of pre-pandemic activity. But most major stock markets have already regained more than 80% of losses incurred as the coronavirus shock unfolded in February.
That bet hinges on a quick return to growth as lockdowns ease. But it also assumes benchmark interest rates have taken another leg lower in their 30-year downtrend and aren’t coming up again soon if the mountains of government debt incurred to fight the virus are to be serviced easily over time.
Thanks largely to the Fed, the average interest rate on all interest-bearing U.S. Treasury debt dropped 44 basis points between January and May — about 2 percentage points below where it was at the depth of the 2008 crash. That is despite U.S. net debt as a share of GDP vaulting more than 30 points to above 100% over the decade.
And despite a brief jolt in March before the Fed stepped in, the drop in dollar borrowing costs for double-A credit-rated companies has been even steeper — 80 basis points since January and 6 full percentage points in 10 years.
The drop in “risk-free” rates and corporate bond yields over the past decade — and again this year — has been a powerful driver of equity valuation models working off discount rates to calculate net present value.
But allowing benchmark bond markets to rebalance naturally as the recovery takes hold could jeopardise the rebound itself, by retightening financial conditions and reversing stock markets’ optimistic return to square one.
Economists at Oxford Economics said on Tuesday that risk assets are not ready for a “discount rate shock”.
“A sharp move higher in real yields in a tantrum-style sell-off will be particularly bad for the growth-stocks heavy US market,” they wrote, referring to the “taper tantrum” that pushed up yields as the Fed slowed asset purchases in 2013.
But even if the Fed doesn’t announce formal yield curve targets later on Wednesday, many investors now assume it will eventually have to do so or reap another whirlwind.
“The uncharted territory that policymakers have entered makes policy execution particularly important,” asset manager BlackRock told clients this week. A key aspect of this policy revolution, it added, is “the explicit blurring of fiscal and monetary policies, including central banks absorbing new government debt to maintain low bond yields.”
(The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own)
(By Mike Dolan, Editing by Catherine Evans Twitter: @reutersMikeD)
