Beware bear steepening

This article, which is a bit more technical than normal, argues that in reality interest rates have already started to rise.

Those who are obsessed with responding to the debate about “tapering” by America’s Federal Reserve could be doing the financial equivalent of fighting the last war. Credit is tightening whatever the unconventional measures being marshaled by central banks.

Many market participants have missed this important point because they have accepted the notion that central banks set interest rates. Strictly speaking this is only partly true.

Central banks, through their open market operations, play an important role in determining short-term rates. In effect they can enlarge or contract the amount of money circulating in the economy.

But long-term rates are more prone to influence by market forces. Bond yields can rise or fall depending on supply and demand in the market.

At present the market is undergoing what fixed income types call a “bear steepening”. In plain English this means that long rates are rising more rapidly than short rates.

On paper, judging by official rates, it might appear that monetary policy is loose and credit is freely available. In reality credit is becoming increasingly expensive.

Essentially a battle is going on between state institutions and market forces. Western governments have huge resources at their disposal so it would be a mistake to assume they will simply roll over. They will keep interest rates low, use unconventional measures such as quantitative easing and promote forward guidance to keep monetary policy as loose as possible.

However, there are at least some market participants who argue that after five years of intense effort this strategy is losing efficacy. Neil Dwane, the chief investment officer for European equities at Allianz Global Investors, says: “The jawboning on short rates is now not working”.

It would be wrong to see this as a conscious battle with the financial markets deliberately trying to undermine the government’s loose monetary policy. What seems to be happening is first of all that official easing is losing its impact. Although central banks are still pumping money into the economy there is already so much circulating already that its effect is diminishing.

The classic analogy is with giving a man a pint of beer. If he is thirsty the beer is likely to be beneficial and could even, in an extreme case, save his life. But the beneficial effect of each additional pint of beer is likely to diminish until its consumption could conceivably become counter-productive.

Falling investor demand is the flip side of the discussion. As investors become less interested in supplying credit the demand for bonds can fall and yields consequently rise. This does not come about as the result of a conspiracy but because attractive investment opportunities have diminished.

Although this trend can be seen in America and Europe it does not work in exactly the same way in each region. The supply of credit in Europe is far more intermediated – with companies often preferring to borrow from banks rather than tapping the markets directly.

Nevertheless there are signs that a battle between the authorities and the markets is in its early stages. Tapering could become yesterday’s news before too long.

This blog post first appeared last Friday on Fundweb.