Central banks won’t end the party
Investors are increasingly worried about overvaluation and bubbles in some segments of the financial markets. Since monetary policy of the major central banks were instrumental in fostering the current risk taking environment it is unlikely that they will look to remove liquidity in a disruptive manner.
If there is any fallout from a normalisation of policy it will be as a result of an increase in the risk-free rate which would encourage investors to be less complacent and more cognisant of the liquidity and volatility risks involved in carry trades.
Central banks have played a key role in preventing tail risk outcomes through the novel use of their balance sheets and interest rates close to zero. There has been a deliberate strategy to force savers/investors to shift away from cocoon type behaviour towards taking more risk and for some this has created new challenges with regards to financial stability.
Had low inflation been a concern for the Fed or BoE then maybe they too would have relied on macroprudential/regulatory measures as in Sweden or Switzerland. Instead the BoE and Fed both see a normalisation of interest rates as necessary with both warning of the possibility that lift-off could start sooner.
Eventual lift-off and then normalisation does not mean that central banks will step back completely from supporting risk markets. Forward guidance scripts from the Fed and BoE have been designed to reassure markets by highlighting that normalisation will not happen in an abrupt and aggressive manner.
Unlike previous tightening cycles the Fed and BoE will also be looking to eventually reduce the size of their balance sheets by unwinding QE related asset purchases. Policy makers are cognisant that in the quest for yield investors have not been adequately compensated for liquidity and volatility risk.
How high the risk-free rate has to go before investors desire greater compensation is unclear and it may take very little for what starts off as an orderly shift toward the exit turning into a stampede. Making things worse is the fact that since the start of the financial crisis, we have witnessed a reduction in the number of willing risk takers. Just take a look at what happened during last year’s taper tantrum where a NY Fed study suggesting that an unwillingness by dealers to “supply liquidity amplified the sharp rise in rates and volatility” during May and June 2013.
Whether markets are irrational, overvalued, or in a bubble will not be known until after the fact but investors can prepare by taking a more diversified approach to investing.