Market Mechanics | Central Banks: The New Old Normal
For much of the period since the Global Financial Crisis, central banks have not simply set interest rates, they have also sought to manage expectations about where rates might go next.
Forward guidance, policy projections and, in the US, the Federal Reserve’s infamous “dot plot” helped anchor the expected path of short-term rates. At the same time, quantitative easing made central banks major buyers of government bonds, reducing the amount of duration private investors needed to absorb and contributing to lower term premia and rates volatility.
That framework is beginning to change, potentially marking a regime shift in global bond markets.
Fed Chair Kevin Warsh has been unusually explicit. At Jackson Hole in August, he argued that regular forward guidance had “overstayed its welcome” and that, in normal times, markets should play a greater role in forming their own expectations. The Fed is also reviewing its communications framework, while other major central banks continue to reduce the footprint of their balance sheets.
For bond markets, this matters.
Less guidance means greater uncertainty around the future path of short-term rates. Smaller central-bank balance sheets also leave private investors to absorb more government bond supply at a time when fiscal deficits remain large, and issuance requirements are increasing.
The effects are increasingly visible at the long end. US 10-year Treasury yields have reached levels last seen more than two decades ago. In the UK, 30-year gilt yields have risen above 6% for the first time since 1998, while fiscal concerns have driven significant repricing across European government bond markets (Bonjour nos amis français). Japanese government bond yields have similarly moved towards multi-decade highs.
These moves reflect more than expectations for the next central-bank meeting. Longer-dated bonds increasingly need to compensate investors for uncertainty around inflation, fiscal policy, supply and geopolitics.
But perhaps the more interesting question is whether this really represents a new and unusual environment at all.
For much of the period before 2008, nominal interest rates and government bond yields were materially higher, yield curves were less heavily influenced by central-bank balance sheets, and rates volatility was greater. Viewed through that lens, the extraordinary period may have been the decade and a half after the financial crisis rather than the environment emerging today.
What feels like a regime shift may in fact be a return towards normality – markets carrying more of the responsibility for price discovery, investors demanding compensation for duration and uncertainty, and curves moving more freely in response to differences in policy, fiscal positions, supply and demand.
For relative value investors, that matters.
Greater uncertainty does not simply mean greater directional risk. It can create more dispersion between countries, maturities, curves and instruments as markets adjust at different speeds. Relationships compressed by abundant liquidity and predictable central-bank intervention may become less tightly anchored.
Central banks stepping back therefore has the potential to expand the relative value opportunity set.
The less central banks determine the shape of markets, the more work markets have to do themselves, and the more opportunities there may be when they get the relative pricing wrong.
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