William De Vijlder

The recent meetings and press conferences of the Fed and the ECB have confirmed that their message remains unambiguously hawkish, perharps slightly less than in the past but nevertheless the determination to continue to tighten policy is still very much there. However financial markets are pricing in rate cuts already toward the end of this year. This seems kind of reminescent of what the first ECB President, Win Duisenberg, used to say at his press conferences: “I hear what you say but I am not listening”. Are we now experiencing an example of markets not listening to what central banks try to convey as a message.

Two explanations spring to mind. The first one is that it would simply be a case of diverging views. The assessment of the economic outlook by markets would be very different from that by the central banks.  A more likely explanation which I favour is that investors are rationally managing their risk exposure.

Let’s now look in more detail at the second explanation. We can actually say that financial markets and central banks are playing a game of cat and mouse. Central banks through their decisions and communication try to influence market developments because that in turn has an influence on the real economy. Financial investors also influence what central banks do and say.

From the central banks’ perspective, it is clear that in the near-term they will continue tightening policy: core inflation is too high and we have not yet reached the peak level of official interest rates in this cycle. They will continue policy tightening but also it is clear that they have no incentive whatsoever to already soften guidance too early. They have all the time to wait for that and to see how the data evolve. Actually central banks have the option at any moment in time to change their message to the markets and the timing of using that option to change their message will depend on how the data come in.

The markets’ perspective is to some degree the mirror image from that of central banks. Markets know that an unexpected change in guidance would have a major impact on bond yields, softening of guidance would mean that bond yields would drop and equity markets would rally. Markets also know that central banks have the option to change their message at any moment in time and that that option depends on the data. Markets also remember that in the past central banks have already surprised, think of when they started tightening policy which also came to some degree as a surprise.

So it means that investors know that if you wait until the big announcement is made, it will be too late because everybody will try to squeeze through the same door. Markets also understand that the smaller the gap between the current level of policy rate and the terminal rate, the higher likelihood that the central banks will actually start changing their tone and will adopt more dovish communication about their future policy intentions. As a consequence, investors decide that it is better to anticipate rate cuts well ahead of time rather than waiting until they have happened.

Central banks have their rationale and financial markets have their own motivations. What are  the consequences of these different approaches? The first consequence is that by the time that central banks change their guidance, it should be largely priced in by bond and equity markets.

The second consequence is that in the meantime, what you are observing is a phenomenom of  FOMO markets. FOMO (Fear Of Missing Out): investors are afraid of not having invested sufficiently in bonds by the time yields drop further or in equities because when interest rates go down it should have a beneficial impact on equity markets. FOMO behaviour means you have a very nervous environment fuelled by data, because sometimes data are strong (we have seen that with the latest US labour market report). As a consequence bond yields moved higher and there was a reassessment of the timing of the first rate cut by the Fed.  All this means more volatility. It gives us economists an opportunity to communicate to you.

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