(Reuters) - Are markets challenging central banks - or is it the other way around?
There may be good reason for central banks to muddy the waters in a period of inflation uncertainty - not least to jar complacent investors from betting on cheap credit forever. But this could come with a hefty price tag.
Seismic moves in interest rate markets in recent weeks followed a mix of new signalling by major central banks that basically rendered unreliable their previous insistence on borrowing rates staying near zero for the next year or two.
So-called "forward guidance" has got murkier and it culminated last week in outright policy surprises.
Most obviously, the Bank of Canada abruptly abandoned bond buying and signalled a rise in interest rates early next year. Then, after days of an eerie "no show" on open markets, the Reserve Bank of Australia (RBA) formally ditched its yield curve target of 0.1% this week and swore it was unlikely to return.
Even though the RBA dissed speculation about policy rates rising next year, money markets continue to price in as many as three quarter-point hikes through 2022.
A month of hawkish Bank of England speeches, meantime, has stampeded money markets toward a possible UK rate rise as soon as this Thursday - and more than a full percentage point within 12 months. Such an early move had neither been warned of, nor bet on, as recently as August.
And what was seen as equivocal language from the European Central Bank last week has led to a hardening of money market pricing for a small hike in its deeply negative policy rate in 2022 despite overt ECB protestations.
In effect, markets are now ignoring explicit guidance from at least two of the world's leading central banks.
This ups the ante for the U.S. Federal Reserve this week. The Fed is set announce an imminent tapering of its $120 billion a month bond-buying programme, but markets are already priced for at least two policy rate hikes next year, with Goldman Sachs forced late last week to abandon forecasts for no rate rise at all in 2022 and now match the two hikes embedded in the rates curve.
"Central banks have lost - or are very close to losing - control over interest rates," said Chris Iggo, chief investment officer, core investments at AXA Investment Managers.
"Now the inflation cat is peaking out of the bag, the incumbent framework for setting rate expectations is perhaps inadequate," Iggo added. "It's almost as if central banks want the market to do their work for them."
GUIDING LIGHT
The idea that central banks might want markets to tighten up without necessarily going as far themselves is not fanciful.
Central banks didn't always tell markets what they were going to do next. For years, an element of uncertainty was considered an important part of how markets functioned, long-term risk premia were considered healthy, and central banks reserved the right to act as necessary.
Fed watchers were akin to Kremlinologists at one point - reading the tea leaves of speeches and deciphering open market operations, often taking more than 24 hours to work out if the main policy target rate had changed or not.
The Bundesbank's approach of the 1980s and 1990s was riddled with surprise decisions - open in telling markets what framed policy but never what it planned to do next.
Gnomic communication was a hallmark of former Fed chair Alan Greenspan too and he once quipped that if he sounded clear, "you've probably misunderstood what I've said".
And yet Greenspan's chastening experience trying to tighten fast to control soaring bond yields in 1994 drew him to more explicit forms of forward guidance to help control expectations and long-term borrowing rates whenever policy rates rose. He then conditioned markets with predictable quarter-point hikes from meeting to meeting through the early 2000s.
His successor Ben Bernanke went even further by presiding over a commitment to unchanged policy rates for two years in 2012 and he since described forward guidance as policy tool in itself - especially when interest rates neared zero.
Further afield, former Bank of England chief Mark Carney got labelled an "unreliable boyfriend" for dabbling in guidance around future policy triggers he subsequently didn't honour. Central banks in New Zealand and Norway have gone as far as openly forecasting planned policy moves at regular meetings.
However, the role of guidance in reducing market uncertainty over long time horizons has arguably fuelled risk taking - with those predictable metronomic Fed moves to cool the housing boom in the 2000s blamed by many for contributing to the credit explosion and eventual banking collapse in 2007/08.
Liquidity swells around the pandemic and bubble-like behaviour in risky stocks or crypto tokens may, for the financial stability arms of many central banks at least, mirror that period's over-confidence in cheap credit far into the future.
"I've always disliked the forward guidance era as it encourages markets to pile on to much riskier, one-way positions than a normally functioning market should naturally allow," said Deutsche Bank strategist Jim Reid. "But to go from forward guidance to silence is a recipe for huge market turmoil."
Be careful of what you wish for, in other words. Whatever regime is preferred, uncorking long-dormant bond market volatility can be a hefty price for pricking overexhuberance at such a fragile time for the world economy - not least under the weight of such gigantic pandemic debts.
By Mike Dolan
