The markets are in the process of re-pricing the Fed and BoE outlooks as ZIRP expectations are extended and yield curves flatten.
What we are witnessing is a continuation of the risk reduction process as volatility continues to edge higher and players rush to convert paper profits. We had for sometime viewed being long bonds as a perfect hedge as they were not only outperforming equities this year but were also positively correlated.
What we have to be cognisant of are the pockets of illiquidity that policy makers, from the IMF to the BIS, have been warning us of for sometime. The unwillingness of market makers/traders to supply liquidity due to a sharp rise in volatility is a factor that risks feeding onto itself.
We had been heading toward a quiet end to QE3 last month with the Fed slowly shifting the market focus toward tightening in Q2/Q3 2015. The return of risk aversion reflects the fact that monetary policy has had a more significant impact in promoting financial risk taking as opposed to economic risk taking.
While it is tempting that policy makers might change this script it is likely that the prescription will be an extension of the lower-for-longer theme as well as more policy easing (from BoJ and ECB). But something that should not be dismissed easily is increased cooperation between the central bank and fiscal authorities.
A weak version of this cooperation is something that Draghi has been attempting to force Germany/EC to accept without success. But a stronger version would be for fiscal policy to be expanded for growth enhancing investment purposes and if necessary for this to be funded by the central bank via special bonds.