The ‘What If’ Question Haunting Markets: Policy Success by Reuters

By Mike Dolan

LONDON – Voter rebellions, a surge in protectionism, potential recession, and Islamic militancy are all concerns, yet perhaps the most surprising event for global markets would be if central banks actually achieved their inflation targets.

After nearly a decade of near-zero or even negative interest rates, alongside trillions in stimulus measures, major central banks have managed to ignite a sluggish economic expansion, creating jobs in the process. However, they have struggled to boost wage growth for many segments of the population or maintain consumer price increases consistently above the desired 2 percent mark.

The financial markets have largely lost faith that these targets will be met—some doubt they can be achieved within their lifetimes. Inflation expectations reflected in interest rate derivatives and inflation-linked bonds are projected to remain below target at least until 2026 and, in some cases, even until 2046. Long-term sovereign yields in countries like Japan, Germany, the UK, France, and Switzerland are similarly falling short of these targets.

There are suspicions that the extensive bond-buying practices, intended to inject banks with newfound liquidity—still ongoing in Japan and the eurozone, and possibly revived in the UK—have distorted market pricing, diminishing its reliability.

The U.S. Federal Reserve halted its quantitative easing nearly two years ago but has similarly struggled to meet its inflation objectives or convince markets of a future in which it can do so. The Fed’s preferred measure of inflation—the core Personal Consumption Expenditures index—has remained stubbornly below the 2 percent goal for eight consecutive years.

"In light of the Fed’s failure or reluctance to reach its target year after year, inflation expectations at the 2 percent level would be nearly irrational at this point," wrote economist Ted Wiseman from Morgan Stanley, noting that his forecasts indicate a decade of missed targets.

The inability to stimulate sufficient economic activity to elevate wage levels and inflation expectations is significant for governments, households, and businesses for various reasons, including encouraging consumer spending, fostering private investment in production and innovation, sustaining debt levels, and maintaining political stability.

For financial markets, the prevailing belief that central banks will be unable to meet their targets for years to come has led to notable behavioral shifts and herding patterns, meaning any signs of success could lead to substantial market reactions.

With monetary stimulus appearing insufficient on its own, governments may need to adopt a combination of fiscal spending and monetary measures to address the situation. Recently, Japan indicated a shift in policy direction, announcing plans for 7.5 trillion yen in new government spending, likely financed by issuing long-term bonds, just after the Bank of Japan decided to enhance its equity purchases instead of bonds.

This change in policy could challenge entrenched market expectations. The 25 basis point increase in 10-year Japanese government yields this week—the largest in three years—illustrates this shift.

MARKET EXPOSURE

But how vulnerable are global markets to changing assumptions? Equity prices are nearing record highs, despite stagnant corporate earnings growth, as global fund managers surveyed recently are pivoting away, with bond and cash holdings surpassing equities for the first time since the financial crisis.

At the same time, bonds have grown exceedingly expensive, with historically low yields undermining their traditional fixed-income role. German 10-year Bunds, with zero percent coupons, mean that any increase in yields could lead to significant losses on what is generally considered a ‘risk-free’ asset.

If markets genuinely believed that the European Central Bank would achieve its near 2 percent target over ten years, and that 10-year Bund yields would at least reflect that, bondholders could face capital losses exceeding 20 percent.

Fitch estimates that if nearly $38 trillion in investment-grade government bonds reverted to 2011 yield levels rapidly, the market could incur losses of up to $3.8 trillion.

What does this mean? Assuming that central banks will persistently attempt but ultimately struggle to achieve inflation goals suggests a scenario where they can avert recession yet fail to generate sufficient growth to elevate prices.

In an environment shielded from the sharp equity declines typical of economic downturns, basic yield comparisons make the 3.6 percent dividend on European equities and the 2 percent on U.S. equivalents more appealing compared to nearly zero or negative government bond yields.

Citi’s assessment of the global "equity risk premium," which adds expected growth to current dividend yields across major developed economies and contrasts it with the average 10-year government bond yield, reveals a staggering 5.3 percent—substantially above the 25-year norm of 3 percent and exceeding most other peak bull or bear markets, except for 2009.

As conservative investors increasingly rely on equities for income, while treating bonds as vehicles for capital gains, the potential impact of successful monetary policy could be considerable, squeezing equity risk premiums and weighing down already expensive stocks.

"Markets are skeptical that policymakers will meet their inflation goals," noted Robert Buckland, Citi’s global equity strategist. "The real surprise would be if they actually did achieve these targets."