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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.
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