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"Who Moved My Punch Bowl?"- Morgan Stanley Says A Repricing Of The "Central Bank Put" Is Imminent

Some potentially displeasing "Sunday Start" thoughts to market bulls, from Chetan Ahya, Morgan Stanley's global co-head of economics, who warns that in light of the recent "hawkish tilt" by central banks, the message is clear: "central banks are more watchful of financial stability risks: It is in this context that central banks now appear to be keen to lean against easy financial conditions so as to pre-empt the rise of financial stability risks. To assess financial stability risks, Fed Vice-Chair Fischer had recently highlighted the Fed’s framework in a recent speech in which he highlighted the “four broad cyclical vulnerabilities: (1) financial sector leverage, (2) non-financial sector borrowing, (3) liquidity and maturity transformation, and (4) asset valuation pressures”."

As a result, "financial stability risks will hold the key: In the 2004-07 episode, as inflation was well-behaved, the pace of monetary tightening by central banks was slower than warranted, which resulted in a build-up of financial stability risks as financial conditions stayed easy, private sector leverage in both the non-financial and financial sector rose sharply and asset markets were buoyant."

All of which means that "markets will therefore have to deal with the repricing of the central bank put – a key feature of the post-crisis world: Whether policy-makers are tightening via rates or balance sheet actions, or imposing more macro-prudential norms, the message is clear – the global monetary policy stance has taken a hawkish turn and will continue to do so."

* * *

His full note below:

Who Moved My Punch Bowl?

By Chetan Ahya, Morgan Stanley's global co-head of economics

Global central banks have sent out hawkish signals, as evident from the ECB president’s speech in Sintra, the release of the FOMC meeting minutes and in the UK Governor Carney’s remarks last week followed by the statement from the Prudential Regulation Authority on consumer credit. Bond yields in the US, Germany and UK have risen by 23bp, 22bp and 25bp, respectively in the past two weeks, partly reflecting the repricing of central banks’ policy response. We don’t think this disrupts a synchronised global recovery, but it has the potential to boost USD and rate volatility, and drive US credit underperformance.

Amid this hawkish tilt, central banks appear to be dismissing the recent weakness in inflation prints: Incoming inflation data prints have been subdued, particularly in relation to central banks’ targets. However, as we have explained in a previous Sunday Start, part of the recent weakness in inflation has been due to sector-specific or idiosyncratic factors which are in turn predominantly due to supply-side adjustments, rather than a reflection of weak underlying aggregate demand.

Indeed, global growth is holding up well, as the latest GDP growth tracking estimates for the US and euro area point towards 2.8%Q and 2.7%Q SAAR growth in 2Q17, up from 1.4%Q and 2.3%Q SAAR in 1Q17, respectively. Moreover, the ISM/PMI prints in the US, euro area and China have held up well too, with the headline prints the highest in three years in the US, at a six-year high in the euro area and close to a five-year high in China. In particular, the forward-looking components like new orders and new export orders have risen too, in some cases to multi-year highs. Against this robust economic growth backdrop, we believe that output gaps will continue to narrow, labour markets will continue to tighten and wage growth and generalised demand-pull inflation pressures will lead to a pick-up in inflation.

In this context, as long as growth stays on the recovery path, central banks should continue to remove monetary accommodation: This view was most recently articulated by ECB President Mario Draghi when he alluded to the need to adjust policy parameters in order to keep pace with the economic recovery.

To be sure, central banks are not necessarily just watching inflation: As has been the case in the previous two business cycles (which amounts to a 20-year period), inflation has not breached the 2%Y target of most DM central banks. Indeed, we expect only a gradual rise in G3 aggregate core inflation to 1.7%Y by December 2018. In other words, an inflation surge may not be the key reason why central banks will tighten aggressively and bring about an end to the business cycle.

Rather, financial stability risks will hold the key: In the 2004-07 episode, as inflation was well-behaved, the pace of monetary tightening by central banks was slower than warranted, which resulted in a build-up of financial stability risks as financial conditions stayed easy, private sector leverage in both the non-financial and financial sector rose sharply and asset markets were buoyant.

In this cycle, central banks are more watchful of financial stability risks: It is in this context that central banks now appear to be keen to lean against easy financial conditions so as to pre-empt the rise of financial stability risks. To assess financial stability risks, Fed Vice-Chair Fischer had recently highlighted the Fed’s framework in a recent speech in which he highlighted the “four broad cyclical vulnerabilities: (1) financial sector leverage, (2) non-financial sector borrowing, (3) liquidity and maturity transformation, and (4) asset valuation pressures”.

As non-financial private sector leverage and asset valuations have risen, central banks in DM are therefore adopting a hawkish tilt in order to lean against the build-up of potential financial vulnerabilities: For several years post-credit crisis, DM central banks had to persist with unconventional monetary policy support as both the private financial and non-financial sector were risk-averse and deleveraging. Today, private sector risk attitudes in DM are normalising, and in fact the private sector is now re-leveraging in several parts of DM, particularly in the US. Indeed, normalisation of private sector risk attitudes is one of the key reasons behind our bullish view on global growth and why we expect central banks to take away monetary accommodation.

Markets will therefore have to deal with the repricing of the central bank put – a key feature of the post-crisis world: Whether policy-makers are tightening via rates or balance sheet actions, or imposing more macro-prudential norms, the message is clear – the global monetary policy stance has taken a hawkish turn and will continue to do so. For markets, we think this can support USD over the next several weeks, especially against JPY, as US economic surprises bottom and USD positioning is light. We think that US rate volatility can rise from historically low levels, especially in the front end. And we think that a late-cycle environment colliding with less central bank accommodation will lead to US credit underperformance versus equities.