Central banks leave punch bowl out too long

21 March 2016

William McChesney Martin, Chairman of the Federal Reserve in the 1950s and 1960s, is quoted as saying the “Federal Reserve is in the position of the chaperone who ordered the punch bowl removed just when the party was really warming up.” In a client note titled “Party Time”, Simon Masnick, Westpac’s global head of fixed income trading, reckons Janet Yellen and the Fed will ignore this tenet of central banking because they are sick of taking the rap for Europe and Japan. He thinks the Fed has capitulated to a desire for a weaker USD, which is entirely inconsistent with rising US interest rates in a world filled with negative ones.

Despite a US economy doing well and “years into a sustained recovery” the Fed went dovish in recent months because it did not want the US to be the economy which “takes the strengthening currency pain for the rest of the world to gain”.

“Janet Yellen and her FOMC decided enough was enough…And so they sprung a dovish surprise on a market that, mistakenly, believed the Fed was in a tightening cycle.”

He has two pieces of advice to bond investors.  The first is, don’t fight central banks too early. “Cash bonds are the best place to play, following the adage you want to be on the same side as the ECB and they’re buying bonds, not selling protection.”

The second is to buy inflation-linked bonds. This advice is based on the view the ECB and Fed will be left with a “policy mistake”, which implies the policies of the ECB and the Fed will lead to an outbreak of inflation which vanilla bonds will not have taken into account. “Sure the amount of slack in the US economy is plunging to new lows; sure there are signs of inflation creeping in everywhere; sure the economy still has emergency monetary policy settings despite being years into a sustained recovery…throw in the added Tabasco of an ECB that will buy any bond ever issued in Euros, ever, forever, and you’ve got a big QE/dovish shot in the arm.” In other words, too much money for too long will spark inflation beyond what markets are currently expecting.