The Great Reversal: Part II (volatility and the real economy)

Volatility in global markets has continued, with a developed economy - Japan - joining Brazil in becoming a bear market, meaning that stocks in these two countries have both fallen by more than 20% since their May peaks.

Plus, bond investors are concerned about the growing market volatility and expected rise in interest rates, such that the number of companies tapping the bond market has dropped dramatically as those investors pull back.

In my prior post, I wrote about the signs of a potential end to the era of cheap money.

Investors are jittery, and thus the markets are volatile. But, the impact on the economy should be moderate if central banks reverse their actions in a measured manner.

The nervousness comes from the unknown aspects of reversing a record amount of cheap cash out of the global economy.

Exit strategy

First, a reminder that central banks have injected over $12 trillion in cheap cash into the world economy since the global financial crisis. It is equal to one-sixth of global GDP.

The recent sell-off in global markets (stocks, bonds, currencies, commodities) is a signal that investors are preparing for the possible tapering off of the Federal Reserve's quantitative easing programme as the US economy improves.

Plus, with central bankers periodically warning about bubbles in the stock market, it's unsurprising that some are beginning to think about when and how the world's central banks turn off the cash tap.

Not knowing the answers to those questions may contribute to the nervousness and volatility in global markets.

Here are some possibilities in terms of the "exit."

An "exit strategy" from very loose monetary policy is when a central bank has a plan to raise interest rates and sell assets (government bonds and others), to re-absorb the money that it had injected into the economy.

For instance, the Fed could decide to first raise rates and then gradually sell the government bonds that it owns.

But, does the sequence matter - if it is a rate rise first or re-absorption of liquidity?

Uncomfortable position

If a central bank first raised interest rates, say gradually up from nearly 0%, then the demand for credit will fall.

This supports the aim of taking cash out from the economy that the central bank wants to achieve when it sells the bonds that it holds.

Once a central bank starts selling government bonds, it increases the supply so the price will likely fall.

As the price is inversely related to the yield on the bond, then anyone buying the bond could receive higher returns on lending to the government and the price is lower than before. It could attract new buyers and help the central bank reduce its balance sheet.

But, existing bondholders may want to get out before the exit strategy starts, because the larger supply may well push down the value of their holdings, so they could lose.

There is also a chance that the central bank could lose from their existing holdings of government bonds for the same reason, e.g. recall the Bank of England mentioning it.

Now, if a central bank were to sell bonds first and then raise rates, it may find that the price of money - which is what the interest rate is - is largely out of their hands. That may not be the most comfortable position for a central bank to be in.

Long-term rates are determined in the bond market, while central banks traditionally control short-term rates.

So, the benchmark or key rate set by the Fed is the 0-0.1% that determines short-term borrowing cost.

But, most lending in the economy depends on long-term rates - for example 10-year US government Treasury bonds are more influential than short-term rates in terms of the cost of a mortgage.

And those are largely determined by bond markets.

For instance, the yield on a 10-year government bond would depend on the short-term rate, expected inflation, economic growth and thus the expected interest rate a decade from now.

With the large amount of bonds to be released back into the market, a central bank may find that the bond market will do a lot of the dictating.

Though the Fed has re-discovered the ability to affect the yield curve (yields on short- to long-term US government bonds) through its Operation Twist, which was first done in the 1960s.

So, perhaps the jury is still out.

Healthy sign?

In terms of the impact on real economy, when there is a steepening yield curve (longer-term rates rise more than short-term ones), it is usually a sign that growth and therefore higher interest rates are expected in the future.

In other words, a sign of recovery.

There are certainly concerns about how the reversal will go. The nerves are evident in the volatile markets.

But, for the economy, a return to a time when savers earn a return, markets are not so bubbly, and growth resumes would be welcome.

It may not happen very soon, but when the time comes, an orderly "exit" could be a sign of better times ahead.

Just brace yourselves though, as it may be bumpy for a while.