How Central Banks Lost Control

23.06.2016 • Politics and War

From Money Week (Great Britain)-

In the Great Train Robbery of 1963, the theft of £2.6m in cash from a Royal Mail train travelling between Glasgow and London was accomplished by tampering with the line signals in order to stop the train. As robberies go, it was audacious. The haul was worth around £50m in today’s money. But as criminal masterminds go, the gang of 15 robbers who pulled off one of the most infamous heists in British history can’t compare to the current gang running the world’s central banks. Those people – Janet Yellen, Mario Draghi, Mark Carney, and Haruhiko Kuroda – have pulled off an even greater heist. By tampering with price signals – short-term and long-term interest rates – those central bankers have put trillions in global savings at risk. While the world has focused on the risks of Brexit, a bigger and more dangerous risk has emerged – that the “endgame” for central banks results in massive falls in both stock and bond prices.

Unprecedented distortions

That interest rates could rise again – contrary to the expressed interests of central banks – may seem a remote possibility. After all, the US Federal Reserve has already backed off on its plan to “normalise” rates this year. The immediate culprit was the weakest jobs report in six years in May. Markets expected 160,000 jobs to be added – instead they got 38,000. As a result, traders now reckon there won’t be another US rate hike until February 2017, and Fed boss Yellen has done little to discourage that view. In response, ten-year US Treasury yields touched a low of 1.57% in mid-June.

That in itself wasn’t that alarming. But what happened next was. The “term premium” on the ten-year Treasury bond fell to a record low, turning negative, as you can see from the chart below. What does that mean? Estimating the term premium is not a precise art, but think of it as the extra yield that investors demand for taking the risk that goes with lending over a longer rather than a shorter period of time – inflation might surprise on the upside, for example. As the name implies, you’d generally expect it to be positive – but as you can see, in June, the premium went below zero. In other words, investors are not demanding extra compensation for lending long term – in fact, they’re offering a discount. That’s partly driven by demand for “safe” liquid assets, such as Treasuries, and partly by an expectation that rates will remain low and that deflation is a bigger risk than inflation, which means investors actually see longer-term bonds as less risky than short-term ones (better to lock in a higher yield now than risk being rolled over into a lower one in a few years’ time).

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