BondWorld : “Wild West“ markets, with accommodative Fed and ECB.
Andrea De Gaetano – Independent Analyst
BondWorld – All rights reserved
In an interview with CNBC, Robert Shiller, Nobel Prize, in 2000 anticipated the bursting of the internet bubble, now said that „a Wild West mentality is taking real estate, equities and crypto.“
Shiller is concerned about the bubble forming. But he’s not the only one worried. Central banks are too, and they tiptoe around it.
In the minutes of the Fed’s April 27-28 meeting, the U.S. central bank points to the „diminished risk premium on equity and credit, with potential risks to the financial system given the high leverage of many investors.“
The ECB’s May 19 Stability Review states, „The unequal economic impact of the pandemic implies risks concentrated in specific sectors and countries. Banks‘ asset quality holds, but profitability weakens as credit risk worsens. Disordered market corrections can affect „non-bank institutions“ that have large exposures to companies with weak fundamentals. Financial market optimism contrasts with weaker economic fundamentals, and recent bursts of volatility underscore the risk of repricing.“
In the first quarter of 2021, GDP in the euro area fell -0.6% from the previous quarter after a -0.7% decline in the fourth quarter of 2020.
On the other hand, the US GDP did well, growing at a pace of 6.4% year-on-year.
Manufacturing and services PMI indices expanding in both Europe and the USA. In Europe, the Eurozone economy is reviving with demand growing at the fastest rate in 15 years.
In the U.S., it emerges from the Flash U.S. Services Business Activity Index that private sector companies report unprecedented business expansion in May. The increase in new orders accelerated for the fifth month in a row. Growth in demand for goods and services as the economy reopened contributed to the flare-up in inflation.
Inflation at a rate of 4.2% in the USA and 1.6% in Europe stand in contrast to the still zero interest rates on both sides of the Atlantic.
Yields below zero on European government bonds and just above zero on U.S. government bonds up to two years have diverted investors to HYs, whose yields have returned to pre-pandemic levels.
The FED and ECB attribute a „temporary“ character to the rise in inflation and appeal to the uncertainty of the development of the pandemic, the unemployment level still far from the targets and the potential downside risks for the development of the economy to keep rates at zero and calm the markets. The last thing they would want is financial turmoil that would jeopardize the economic recovery.
Fed Vice Chairman Richard Clarida, May 12 at the National Association for Business Economics International Symposium: „Despite the recent stream of encouraging macro data, the economy remains far from our targets and it is likely to take some time for further progress to be made. Employment remains 8.2 million below pre-pandemic peak levels and participation-adjusted unemployment is closer to 8.9% than 6.1%. We are committed to using all of our tools to support the economy for as long as it takes.“
Klaas Knot, a well-known hawk on the ECB Governing Council and governor of the Dutch central bank, said on May 11 that the ECB will continue to provide support to the recession-hit economy, even after the 1.85 trillion purchase program ends. „the only thing we are talking about is the rotation from emergency support to other forms of unconventional support.“
On May 19, Luis De Guindos, ECB Vice President said that „the withdrawal of monetary stimulus will have to be gradual, very prudent and parallel to the evolution of the recovery of the economy.“
On May 21, Christine Lagarde said: „it is too early to discuss the tapering of the 1.85 trillion purchase plan. ECB committed to maintaining favorable funding conditions using the PEPP until at least March 2022.“
All of this has created a self-feeding cycle in which equity markets continue to rise driven by improving data and lack of alternative, while bonds have negative real yields, not protecting against inflation and not rising in yield thanks to central bank purchases.
Against this backdrop, the very strong rise in government yields, in the US in particular, has already discounted much of the first flare-up of inflation and offers tactical insights into a pause in the movement.
Like any bubble, you’ll know it’s a bubble when it bursts.
For now, we sail by sight, enjoying the wind at our backs, but aware that the wind can change at any moment and there is a coastline full of rocks downwind.
Shiller may be right, but the important thing, as always, is timing.