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“Tantrum 2” uncovering worrisome securities overvaluation?

As US political observers watch the momentous attack on Obama’s Affordable Health Care Act unfold, the world’s financial markets continue to fret over a possible bond bust. Is financial instability about to become important again in the industrialized world? There are a number of things going on here, all of them reported in various financial news outlets. In the most recent installment, the release of minutes from an European Central Bank (ECB) meeting again heightened anxieties about policy tightening around the world. ECB minutes stir debate over retreat from cheap money. The result is a new “tantrum” by bond markets worried over statements that monetary policy is to be tightened, echoing the so-called “taper tantrum,” which occurred after a previous announcement of policy tightening.
This graphic from the Financial Times shows a bump in bond yields, showing that investors are demanding higher compensation to hold paper issued from a wide range of countries.
Financial Times graphic from Wolf column:

1) The policy high wire scenario for US and European government debt, which either a smooth landing or its absence for the bond market when an inevitable tightening takes place. Here not creditworthiness is at issue but short rates that help to support the structure of long rates across the maturity spectrum. (Pre-publication update: Market conditions have eased somewhat following reassuring statements by central bankers, but the implication is that markets only remain on the same high wire.)
2) The risk on–risk off cycle which brings waves of optimism or pessimism about credit risk for the far more-risky securities issued by less-creditworthy US companies and emerging market issuers.
It is proving hard to keep investors from bidding up prices in all of the relevant markets. Broadly speaking, the markets appear to be richly priced to many observers, including Fed Chief Janet Yellen. Jumps in bond yields hint  at a possible break in confidence in lofty valuations of creditors’ promises to pay in the future.
Hyman Minsky was among the theorists of financial crises who saw a pattern of crises developing when the Fed raised interest rates, usually to combat inflation.

Scenario 1 above unfolded a bit more last week, with a market “tantrum” following comments by eurozone head banker Mario Draghi that it might be time for raising rates in Europe. The theory that central bankers just need to raise rates is increasingly belied by their inability to do so without causing turbulence in the markets. An up-to-date analysis of indicators of a possible collapse would be this piece from the FT and this July 4 column by Martin Wolf from the same site. Wolf shows that the key big private debt risk is in China, while noting ongoing issues with euro debt–which, remember, bears the risk of default like the debt of U.S. subnational governments, which is not denominated in the currency of the issuer.

Scenario 2 is analyzed by Gillian Tett, whose analysis—which comes in a commentary on a successful 100-year bond offering by Argentina— more closely takes on Minskyan lines—keying on questions about market faith in creditworthiness for bonds where that is a key valuation issue, as well as possible changes in the central banks’ policy. Tett’s thoughts are in accord with a recent IMF financial stability report. https://www.ft.com/content/0c73b8f4-5670-11e7-9fed-c19e2700005f
My thoughts: central banks generate too much instability if they have sole responsibility for stabilizing the business cycle. Also, high-risk bonds remain fragile independent of much-followed central-bank moves.

1) Up-and-down movements are very risky in any season; one should not underestimate a central banks’ role in preventing financial crashes and stabilizing interest rates themselves by merely keeping rates stable. Countercyclical monetary policy itself should be kept within narrower bounds than most economists believe. (Hyman Minsky emphasized this different central bank role in in the last section of a 1957 academic paper archived as an e-document at the Levy Institute.)
2) we appear to be farther from full employment than the “hawkish” macro position would have it, as shown in this EPI chart of the employment-population ratio from this recent post.

3) To some extent, the central bank should target employment rates in competitor economies; if trade is permitted, slackness in labor markets is also relevant when it is located in other countries. Examples of relevant slackness include recessionary Brazil–and most of industrialized Europe, where unemployment used to stay below an upper bound of 2 to 4 percent almost as a matter of course!
4) Fiscal tools are relevant as countercyclical weapons, partly in light of need over the long term to have more normal rates of return on bonds. So are broad exchange rates. If policy is to be kept steady on average, these could be loosened to allow interest-rate normalization, as argued in the case of fiscal policy even for example by neoclassical economist Justin Wolfers in the New York Times.
5) Fiscal loosening need not have a net cost if it improves efficiency—why not health care for all? And the tax code is capable of being made more rational as well as much fairer to, say, the bottom 90 percent.

The Financial Times perceptively notes the importance of growth in demand to get corporations to invest instead of engaging in what is being described essentially as paper entrepreneurialism. Employment data for May show the press surprised to some extent at the large amount of remaining slackness in the labor market.

The dovish upshot is that policy should be loosened rather than tightened and  that the policymakers do not face insurmountable dilemmas involving costs entailed by any move  in that direction. Moreover, interest-rate policy shouldl not be counted on–as in the New Keynesian analysis–to bear the entire burden.

 

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