Dancing to the wrong tune

Category: Asia, Global

Now is the time for central banks in developed markets to begin normalising interest rates, following an extended period of record lows and unconventional monetary policy measures, according to the Bank for International Settlements’ (BIS) latest annual report.

The organisation, which has no executive power and acts as a sounding board of sorts for central bankers, warned that low rates and quantitative easing in the US, Japan and the eurozone have lulled investors into a false sense of security, causing them to take more punts on riskier asset classes.

“Financial markets have been exuberant over the past year, at least in advanced economies, dancing mainly to the tune of central bank decisions,” the report wrote. “Volatility in equity, fixed income and foreign exchange markets has sagged to historical lows. Obviously, market participants are pricing in hardly any risks. In advanced economies, a powerful and pervasive search for yield has gathered pace and credit spreads have narrowed.”

It cited, however, a “puzzling disconnect between the markets’ buoyancy and underlying economic developments globally”. The BIS said that while global growth had improved, it was still some way below pre-GFC levels, adding that the “transmission chain” between financial markets and the global economy appeared “badly impaired”.

The report urged monetary policy makers in developed markets to reduce the emphasis on stimulus measures, such as those seen in the US, Japan and Europe, and take the opportunity to begin normalising rates. Failure to do so, the BIS said, and central banks could end up “fostering the very conditions they seek to prevent” by encouraging economies to take on too much debt.

The US has of course already begun withdrawing its own set of unconventional monetary policy measures with the unwinding of the Fed’s bond-buying stimulus. The European Central Bank has, arguably, become more entrenched in such measures, in June cutting its deposit rate to an unprecedented -0.10%, while in Japan quantitative easing carries on apace. Out of the developed world’s major central banks, at present only the Bank of England seems to be seriously considering pushing rates north.

The impact of any change in direction of developed markets’ monetary policy of course has a profound impact on those in Asia, with last year’s so-called ‘Taper Tantrum’ prompting a major sell-off in emerging markets, including Indonesia and India.

Of the fund managers canvassed for this month’s feature on the region’s fixed-income market (see pages 16 to 20), consensus was at a premium for if and when central bankers would begin to hike their policy rates, although the general trend seemed to be that mid-2015 would be the earliest.

For the BIS though, this may not be soon enough. “The risk of central banks normalising too late and too gradually should not be underestimated,” its report read.