The hawkish shift is likely a result of renewed optimism over the growth outlook – where there are signs of global growth synchronisation for the first time since 2011 – and, in the absence of meaningful inflation pressures, concerns over financial stability.
Financial markets have taken notice of this new tone, as government bond markets globally have witnessed higher yields.
The sharp move higher in German bund yields following a recent speech by European Central Bank president Mario Draghi highlights the nervousness in the market and the sensitivity of investors to central bank headlines.
After all, it has been almost 10 years since the GFC, and the markets have become addicted to loose monetary policy. This has led to a suppression of volatility across asset classes as investors continue their search for yield.
Any signs that policy may become ‘less loose’ or perhaps ‘tight’ could trigger a spike in volatility and a return to risk aversion.
This is not the first time we have seen a hawkish shift since the GFC. Canada, Sweden and Australia tightened policy earlier in the cycle, only to have to reverse course shortly thereafter.
Moreover, the 2013 ‘taper tantrum’ left a lasting impact on the US Federal Reserve, significantly delaying the Fed’s tightening cycle. So what is different now?
Several years on, bank and household balance sheets have continued to heal.
However, the general backdrop still looks quite tenuous, with debt levels ever higher and demographics more challenging. And if monetary policymakers misstep, there is no room for fiscal or monetary stimulus to clean up any mistakes.
Global central bank hawkishness appears unified by the belief that the traditional relationship between economic ‘slack’ – typically measured by the unemployment rate versus full employment – and inflation still holds.
According to the Phillips curve theory, the low or diminishing levels of slack in many economies should lead to higher price pressures. Yet inflation appears stuck at levels well below central bank targets.
If the theory no longer works, then raising rates now or becoming less accommodative could entrench inflationary expectations at levels well below central bank targets, thus undermining central bank credibility.
So we are watching the slope of global yield curves. A continuation of the flattening trend, where short rates rise relative to longer-term maturities, would be a sign that credibility has been compromised and perhaps also a sign that policy is indeed too tight.
Another concern is that a synchronised global shift towards tighter monetary policy could have a significant impact on the global economy.
In other words, policy moves deemed appropriate for one economy – warranted or not – are amplified when similar moves are spread across many major economies, so that a small degree of relative tightening may have a larger impact on the global economy than might be expected.
For fixed income markets, if more aggressive tightening turns out to be a policy error, we believe interest rates will go lower again.
And even if this is not a policy mistake, given that we are in the late stages of the global economic cycle, we may see short-maturity rates rise while longer-maturity rates remain close to where they are today. This is still consistent with a ‘lower for longer’ environment.
We would need a sustainable improvement in global economic conditions before seeing higher rates across the curve – a scenario not consistent with our base case. On balance, rates are likely to remain in a historically low range.
Pilar Gomez-Bravo is head of fixed income, Europe, at MFS Investment Management.
