‘Tis a puzzlement…

No, we are not reminiscing about Yul Brynner’s indelible role in “The King and I”! Instead, we are wondering about the fact that the developed world seems to be experiencing ever more extreme behaviour by central banks in their quest to sustain, or re-start, economic demand and output, and to ward off the perceived perils of deflation. The result has been a downward spiral of nominal interest rates, until a number of central banks have found it necessary to move below the “Zero Bound” and into a negative policy rate regime.

As is, by now, well documented, this has led to some very strange outcomes in terms of risk versus reward, and to signs of the return of the good, old-fashioned competitive devaluation- truly a zero-sum game, and one fraught with danger for those who become collateral damage.

One can begin to hear the distant (or perhaps not-so-distant) sound of currency pegs failing. Certainly, many are coming under increasing strain, with potential unpleasant consequences for those caught on the wrong side of the carry trade, or FX cross- as happened recently re the Swiss Franc.

And here is a thought to ponder: deflation or ultra-low inflation was, with a few exceptions, the natural order of things for much of recorded economic history; yet, while nominal interest rates were often low, they did not dip into negative territory.

So, now we have an environment in which the ECB is embarking somewhat late on a programme of quantitative easing, with the aim of reigniting animal spirits in the Eurozone and returning inflation towards its 2% target. Unfortunately, inflation expectations, as recorded in market prices, remain in a steadily declining trend, and the stock of Eurozone government bonds with a maturity beyond one year that have a negative yield keeps rising, while economic demand remains generally sluggish, or even falling, notwithstanding some perhaps positive recent signals from some Eurozone countries, including Germany.

Couple this with still inflating and inflated asset prices; and the opportunity for dislocation and unexpected shocks continues to increase. In many ways, we are in uncharted territory in terms of monetary policy and its impact on the real world and people’s behaviour; and, even when intentions are “telegraphed” by central banks trying to manage expectations, past experience would tend to caution that markets will still be “surprised”, with potentially unfortunate consequences for emerging markets and non-US debtors borrowing in US dollars in particular.

As for rapid inflation, the risk of it occurring has a habit of being disregarded a potential problem, until it becomes one!

For Awbury, all we would say is that we are wary of all the conflicting signals “out there”; and that we are quite sure that there will be outcomes of the central bank actions that will be unpleasant and probably unintended. So, we maintain our vigilance; and continue to monitor a broad range of markets and indicators for signs that risks are moving from the realm of the predictable into that of the uncertain and dangerous.

– The Awbury Team


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