Welcome Mr Powell: Monetary Normalisation Is Not Going To Be A Bed Of Roses

Jerome Powell may let inflation drift a little higherJerome Powell at his presentation at the White House

José Ramón Díez Guijarro (Bankia Estudios) | The welcome the financial markets have given the new Fed chairman (Jerome Powell) shows that the end of the monetary normalisation process in the US is not going to be a bed of roses, despite the fact his predecessor (Yellen) left with a good part of the dirty work already well underway.

It’s well known that, in processes of monetary tightening, the two most difficult moments are, at the beginning, when people are told the good times are over (back to harsh reality) and at the end, the final steps in the normalisation process. In other words, it’s as complicated to signal the upward path in interest rates as it is to decide at what moment and level the process should end. Particularly when, as is the case now, you are coming from unexplored territory.

In this sense, as has been demonstrated over the last week, the financial markets’ sensitivity will increase as the US central bank gets closer to neutral levels. Particularly now the gap between the FOMC members’ medium-term forecasts and those discounted by investors has practically disappeared. In other words, the buffer against possible upward suprises in inflation is less, which increases fragility when faced with the doubt whether we could see higher than expected interest rates in the medium-term, above all, if fiscal policy doesn’t help. Which will change all the valuations of the fixed income and equity markets.

So in a short period of time, we have gone from looking for signs of inflation underneath the stones and trying to justify its absence, to being worried again about a possible reappearance of inflation tensions. But the slight acceleration in growth in wages in the US (from 2.7% to 2.9%) which was revealed last Friday, hardly seems to justify the markets’ performance over the last week. It’s been more a case of it becoming an excuse to justify a correction, in the wake of the continued rises in the stock markets over the last few months. These rises had made for very demanding valuations, coinciding maximum levels of investor confidence; paving the way for a breather. Just reminder that in 30 of the last 38 years, the equity markets have ended the year with gains, but with average interannual corrections of 15.3%.

The difference, this time, may be in the changes in the markets’ trading ecosystem. Increasingly more orders have their origin in algorythms, behind which there are the passively managed funds, the risk parity etc. And, linked to the above, in the record low levels of volatility we have seen in the equity markets. All of this has led to return-risk combinations in portfolios far removed from historic patterns. But it appears this illusion came to an end, when the volatility of the most important index of volatility (VIX) rocketed.

In other words, the VIX did not just go from 15 to 50 on February 5 unceasingly, but later we saw it back again at 20 and it ended the week at levels over 30. This reflects the fear of fear and that the nervousness is going to remain for some time.

So we are now facing the correction which was feared for some months and which could still have some way to go.The fact the indices in the US had been rising for such a long time was unusual. What happens with corrections is that the longer they are delayed, they seem to be more violent. The important thing, in the current situation, is that there is no fundamental element which allows us to think we are at the start of a change in trend in the equities market. The problem is that some investors seemed to have confused the new normality with the existence for ever of negative interest rates in real terms. That said, we need to realise that it’s not going to be a bed of roses ahead, because fear is free and the sensitivity of the markets is not going to decrease. In other words, it looks as if the year is going to be a very long one, especially for the central banks. Because, for example, what are we supposed to think of the significant salary rise (nearly 4%) agreed on by IG Metall (an old friend of those of us who have been following monetary policy for years) in Germany? Years ago this would have set off all the alarm bells. Now we should see this as something positive helping the ECB meet its objectives. Or not? It’s what we call the new normality which, sometimes, means that in the end I don’t understand what is happening.