The global economy is still recovering from the financial crash of 2008. While adherents of the Chicago school have no doubts that continued observation of free-market and free-trade capitalist principles will eventually restore growth, there is an ongoing healthy debate about how much we should stick to principle and how much continued state intervention there needs to be.
During the bull market run of 2002-2007 it became accepted belief that markets knew best. But in July 2007, as Western economies teetered on the abyss, A-rated structured finance securities were being issued at Libor plus 30 basis pointss.
A year later the same risk traded at over ten times that, so one observes that markets can also get things spectacularly wrong. So, do we ignore the market henceforth? Not at all.
To apply Winston Churchill’s mantra, free-market pricing is the worst economic system we have – it’s just better than all the others. The key issue now on both sides of the Atlantic concerns interest rates and inflation.
The argument goes like this.
Central banks pumped billions in liquidity into the system, and base interest rates have been at near-zero for two years now. Something’s got to give. If we don’t start tightening policy, we will end up with stagflation.
To which the reply is: “Are you mad? Raise rates now and we simply fall back into slump. We’ll end up with a Japanese-style ‘lost decade’ of zero growth.” Now is not the time for slavish adherence to economic ideology; rather, pragmatic robust logic is called for.
With no crystal ball to guide us, we are left with only one forward-looking indicator: market rates. And they point to something interesting.
In US dollars, the rate for long-dated interest-rate swaps lies below the US Treasury long-bond yield, by more than 20 basis points.
In the UK, this anomaly kicks in even earlier, and reaches 20 basis points by the 20-year tenor.
Does this mean that investors prefer bank credit risk to sovereign credit risk in the long term? No. What these levels tell us is that base rates will need to rise higher than anticipated over the long term, because of the need to tackle inflation.
We see it in the yield spread of government bonds over inflation-linked bonds, nearly 300 basis points in the case of US "TIPS." These levels are worth noting. The conclusion? Central banks should look to start raising rates before inflation gets embedded and becomes a serious problem later. Or to put it more traditionally, a stitch in time saves nine.
Market prices are telling us to worry about inflation, and act accordingly. They could be wrong – only time will tell – but for how much longer should we ignore them? ______________________
The author is Moorad Choudhry, Head of Business Treasury, Global Banking & Markets at the Royal Bank of Scotland and Visiting Professor at London Metropolitan University