Ever since the 2008 economic meltdown, markets have become accustomed to unusual levels of support and guidance from monetary policy makers. Six years on, however, this might be about to change. There are signs that financial markets could see a distinct cooling in their relationship with central banks. With the crisis now in the past, there is a perception among leading thinkers that central banks may have been too indulgent with financial markets, leading to an unhealthy dependence on easy money and raising the risk of asset bubbles.

“Central banks have been running out of scope to assist economies any further,” warns Marc Chandler, Chief Currency Strategist at Brown Brothers Harriman in New York. “Yet markets still do not seem to be prepared for a return to more normal conditions. They still appear reliant on a drip feed of easy money.”

This view was echoed by a report published in June by the Bank for International Settlements (BIS), which serves central banks in their pursuit of financial stability, which concluded that markets had fallen “under the spell of monetary policy”. The organisation cautioned that asset prices were ever more sensitive to even the slightest perceived change in the attitude of central banks. “The Federal Reserve’s first steps towards normalising monetary policy ushered in a bond market sell-off in May and June of 2013 that reverberated around the globe,” the BIS pointed out. It also believes that years of ultra-low interest rates have made financial markets fragile by encouraging “market participants to take positions in the riskier part of the investment spectrum”.

“Everywhere there are signs that investors have taken on very high levels of risk,” says Chandler. “Even though central bankers have warned that interest rates will eventually have to rise, there could be a rude awakening when policy finally starts to tighten.”

 
Treading carefullyThe US, however, appears in no rush to use interest rates to prick bubbles. Janet Yellen, Chair of the Federal Reserve, said recently that she saw no need to consider a rise in interest rates right now. Yellen reiterated her view that governments should seek to preserve financial stability primarily through stronger regulation – something she described as a work in progress.

Risky business Evidence that investors are once again taking on very high levels of risk can be seen in bond markets worldwide.

The gap in yield between safe government bonds in rich countries and riskier corporate bonds has narrowed levels close to those seen before the financial crisis. There is even a strong appetite for more speculative junk bonds, where the risk of default is higher.

Meanwhile, equity indices have climbed to new highs in the US. Even in Europe, investors have been willing to place money again in the government bonds of financially troubled nations like Spain and Ireland again, driving down yields.

More surprising still, in April, investors clamoured to buy a government bond issued by Greece – among the most financially vulnerable European nations – that yielded just 5%.Monetary tightening is expected to begin sooner in the UK, where the strains of returning to business as usual are already starting to be felt, say economists. In June, Mark Carney, Governor of the Bank of England (BoE), announced measures to cool the nation’s housing market, restricting mortgages to 4.5 times a borrower’s annual income and limiting the share of such loans on bank’s portfolios to 15%. By taking this approach, the BoE appears to be attempting to dampen down the housing sector without hitting heavily indebted households with higher rates that could cause another market crash.

“It is not just interest rates that the financial community has to worry about,” says Derek Halpenny, European Head of Global Markets Research at Bank of Tokyo-Mitsubishi UFJ. “Central bankers are starting to become more willing to use other measures to prick asset bubbles that they believe are emerging.”

Still, there are other signs that Britain may be heading for a turning point in monetary policy. In his Mansion House speech in June, Carney warned that interest rates could rise “sooner than markets presently expect”. He was called an “unreliable boyfriend” by the Treasury Select Committee for what it sees as mixed messages and a lack of clarity over the possible timing of interest rate rises. Nevertheless, his speech prompted traders to bring forward their forecasts for the first tightening from early 2015 to as soon as this autumn.


Cooling effectAn early increase in rates would carry certain risks. In July, the pound hit its strongest level against the dollar in more than five years, as investors braced for monetary tightening. “This currency appreciation itself will have a cooling effect on the economy,” says Chandler. “The worry is that you kill the golden goose by lifting interest rates too soon, especially at a time when wage growth is still slow and fiscal policy is being tightened.”

There are also concerns that the European Central Bank (ECB) could disappoint markets. Most economists assume that the ECB is still a long way from withdrawing monetary stimulus. With economic growth still weak and inflation low, the worry instead is that the ECB will fail to do enough to restore growth. “The concern in Europe is still over sluggish growth and falling prices,” says Jennifer McKeown, a former official at the BoE who is now an analyst at Capital Economics. “But the market may still be disappointed at the scale of assistance the ECB is willing to offer.”

Of the major central banks, the ECB has been the most restrained in seeking to revive economic growth, providing only token quantitative easing. “There is a sense that buying large quantities of bonds to revive growth would entail a moral hazard, since the ECB would be buying at least some debt from governments like Italy’s,” McKeown says. “There would be a worry that this could lead to less fiscal discipline from governments that are under pressure to tighten their belts.”


Market sensitivityMost of all, however, investors could be wrong-footed when the Federal Reserve changes course. The sensitivity of markets to even subtle shifts in expected Fed policy was illustrated last spring, after comments by officials were interpreted as a sign that policy tightening was on its way. The effect rippled through global markets, causing a sell-off in sovereign bonds in rich nations and especially emerging markets.

“The Fed has worked very hard to make sure that investors and traders are not caught off guard, and they have plenty of time to adjust to what is to come,” says Chandler. “Fed governors have given a pretty clear idea of how bond purchases will gradually taper off and interest rate increases would only follow about six months after this programme ends altogether.” But he warns that investors have accumulated a large stock of risky assets and may still react poorly when the shift in policy finally comes.

Central banks have been willing to pamper the markets since 2008. Withdrawing this special treatment is unlikely to be an easy process.