The British pound may have strengthened after the Bank of England's threat that it will raise interest rates down the line, but the voices of skeptics are still pretty loud. And who can blame them? Inflation is at 2.9% versus the bank's 2% target, and yet the bank was all talk and no action.
By leaving the interest rate at 0.25%, the central bank effectively put more stimulus into the economy on Thursday by pushing the real interest rate even deeper in negative territory. So, one must forgive people for doubting the central bank's determination to hit its inflation target.
To be fair, while the Bank of England is perhaps the most egregious example of a central bank unable to leave the corner it has painted itself into, it is by no means the only one. The Federal Reserve and the European Central Bank have trouble with ending their stimulus programs as well; even tiptoeing out of them risks upsetting the markets.
North Korea doesn't help. As the recluse communist dictatorship keeps firing missiles over Japan, it adds to already-mounting geopolitical risk. Analysts at Bank of America Merrill Lynch Research noted that investors are still underestimating these risks.
In the research unit's latest credit investor survey carried out last month, only 7% of investment-grade investors and 10% of high-yield investors saw "geopolitical conflict" as a reason to worry for the next 12 months. "Clearly an underappreciated source of risk that is back in the fore," the analysts wrote in recent research.
Central banks, with their stimulus programs, essentially sell low volatility, and the majority of volatility spikes have taken place in periods of uncertainty, they said. This is one of the reasons why central banks will find it hard to break with their dovish pasts.
On the surface, central banks have managed to put a lid on market worries since the global financial crisis, at the price of loading their balance sheets with all sorts of assets. Those who predicted their demise because of this policy so far have been proven wrong.
Hugh Hendry, the manager of contrarian hedge fund Eclectica, which just announced it was closing down, had one last piece of advice for investors: bet on volatility in fixed income. "Fixed-income volatility really has only one direction it can go," he wrote in a letter to investors seen by Bloomberg. It has "overshot to the downside."
It is a pity that Eclectica is closing now when things are likely to become more animated. While the central banks were all singing from the dovish hymn sheet, a contrarian view would have lost any investor a lot of money. No single investor can beat the 800-pound gorilla in the market, which is what the central bank really is.
But now that central banks rhetoric is turning ever so slightly hawkish, things are about to change. The pockets of overbought assets that the central banks have created (to use an euphemism for the hated word "bubbles") could deflate as monetary stimulus is withdrawn.
Still, investors should not fear a crisis of the proportions of the one in 2007-09, according to Adam Slater, lead economist at Oxford Economics. He and his team identified high-yield debt, U.S. auto loans, U.S. commercial real estate and leveraged ETFs as areas of risks, but none of them pose as much systemic danger as subprime mortgages did in 2007.
"The next round of global credit losses, when it comes, looks more likely to be of the type and on the scale seen in the early 1990s and early 2000s, rather than that of 2007-2010," Slater said. Judging by their actions so far, central banks would be wary even of that kind of volatility, which is why they may end up leaving the punch bowl on the table way too long into the party.
