As expected, the Bank of Canada has acted on its more hawkish rhetoric of late by raising interest rates. This newly-found aggression is being mirrored around the world. The mood appears to be changing. But many investors are proving flat-footed in their response to this change in mood.
Much of the recent selling of core government bonds has been felt in futures and options markets. This suggests that many of the sales are computer-driven, sparked by quantitative algorithms; others by hedge funds reacting to price action rather than fundamentals. Data from Eurex, the derivative trading exchange, shows a significant selling of euro denominated government bond products.
But we are not seeing the big flows in cash bond markets that would signal big shifts in major asset managers’ asset allocations. JP Morgan’s investor survey reflects this. It notes that European ‘real money’ investors have only marginally reduced their long exposure. Elsewhere, German government bonds have sold off. Nevertheless, they are a long way from reflecting the direction of travel that European Central Bank President Mario Draghi outlined two weeks ago.
What central bankers indicate in their words is critical to investors.
The point is that the tone from central banks really has changed and – for the most part - investors are sitting at their desks, blinking. As yet, there have not been many tangible policy changes. But what central bankers indicate in their words is critical to investors. We have moved from a world where most central banks pledge unending support for economies to one where they do not. That is significant.
The tardy response in financial markets may be partly down to investor cynicism: a suspicion that this shift in rhetoric will be reversed at the slightest sign of volatility or too strong a reaction in currency markets. But, in the main, it’s likely to be because investors don’t want to give up on the ‘central bank put’ that has been propping up bond markets, and that has been their easiest trade for nearly a decade.
The Canadian economy has comfortably absorbed the oil slump of eighteen months ago that prompted two rate cuts. So it makes sense for the Bank of Canada to reverse them. But the real question is: will the broad mass of investors wake up to the bigger picture?