Central banks: from doves to hawks?

After several months of bond rally, long-term rates for G10 countries are on an uptrend again. The previous phase of yield curve resteepening dates back to Trump’s surprise presidential election victory in the US, with the ensuing hopes of massive fiscal stimulus. Disappointment on 1Q growth on the other side of the pond, along with the executive’s stalemate in the tough negotiations with Congress ended this downtrend on sovereign bonds. This time, the sell-off on fixed income was not due to an improvement in world growth, which has stabilized at a three-year high, or fresh promises of fiscal generosity, but rather was a result of a slew of menacing comments from central banks (Fed, ECB, Bank of England, Bank of Canada, Swedish Riksbank).

Despite different specifics for each of the economies involved, the sound performance from world growth, equity markets on a high and desperately low volatility are shared factors that can explain this change in tone from central banks.

In the US, the UK, Sweden and Canada, central bankers have taken on board an economic situation that is coming close to full employment, with a risk of overheating not of inflation, but rather of private debt and asset prices (real estate, equities).

The Chair of the New York Federal Reserve clearly expressed the Fed’s frustration on flattening of the yield curve since the start of the tightening cycle that kicked off in 2015, which, as it had indicated in a speech in late 2015, would warrant an acceleration in monetary tightening (rate hikes, balance sheet pruning).

In Canada, the change in stance seems to be part of a wider strategy to counter the real estate bubble that has emerged in several states, and includes several macroprudential measures i.e. borrower stress tests, tax on foreign investment.

In Sweden, a small economy that is highly dependent on external trade, the Riksbank has long favored currency competitiveness at the expense of financial stability, to the extent that it let household debt rise to worrying levels.

In the UK, Mark Carney has to deal with an economy that is close to full employment but which will suffer from a political and economic shock from the UK’s forthcoming withdrawal from the EU and high imported inflation.

In these four countries, the danger is that the normalization in interest rates will come too late to avoid a severe correction in asset prices, with retroactive effects on the economy and the prospects for hitting the inflation target, thereby revealing the conflict between the central banks’ institutional mandate (inflation, full employment) and financial stability (role played by wealth effects relating to asset valuations in reaching full employment).
The ECB is not (yet) faced with this dilemma, but it must steer its communication to deal with another ambiguity arising from the conflict between the risk of overheating in Germany on the one hand, and support for debtridden peripheral economies on the other.