ARE INVESTORS OFF THEIR ROCKERS?
Janus’s Diaz is among those who take a more cautious view of the future. “We have never been here before so it is difficult to feel good about the outcome when we have never had to unwind the major global central banks’ engagement in exceptional monetary policy. That unwinding may prove more challenging than many think and there may be complacency in central banks’ ability to unwind those policies.”
There are already signs of a dislocation between where monetary authorities are guiding markets and where markets are priced. The projected medium term path of the Fed funds rate to 2017 has a more than 100 basis point difference between where staff expect the rate to be and what the market is pricing in. This suggests the Fed is likely to withdraw QE faster than the market is currently pricing in.
“One of the biggest risks in the market today is the benign pricing of central bank policy, particularly the US Fed,” Diaz says. “There has to be a convergence. If there is a quick adjustment, that could be particularly disruptive and we could see significant repricing across all risk assets.”
And in the context of investors’ thirst for yield, the repricing could be dramatic. The over-riding feature of how institutional investors are behaving, according to Aon Hewitt’s Datta, is that they are becoming “remarkably price-insensitive”, which naturally encourages pro-cyclical behaviour.
Liquidnet’s Pumfrey says: “People are quite blasé today. They are always prone to optimism until something smashes them in the face. While people can see the risks, they are riding a wave and don’t want to get off. The reality is if there is a surprise shift upwards in interest rates, people will want to shift things around and we will then see big moves in markets, which will have big ramifications for the wider economy.”
If the full scale of the post-crisis decline in liquidity is yet to be fully understood by the markets, then those risks cannot be fully priced in. It also makes it very difficult to understand the extent to which markets are off their normal rockers. Is there complacency about the level of liquidity in the market?
“That’s the million dollar question,” says Janus’s Diaz. “The market has not been properly tested given the extraordinary liquidity from central banks. When liquidity is removed from the system and the curtain is pulled back, we will find out.”
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