The lords of money pose a massive threat to the markets

Do you think the Fed’s job is tough? At least the US Federal Reserve can focus on fighting inflation. In Japan and Europe, central banks are struggling with markets, not just raising prices. This leads to some very strange, even contradictory, guidelines.

The problems facing the three central banks mean that investors should brace themselves for low-probability, high-threat risks that lead to extreme price movements. If central banks unexpectedly go into full reverse gear, watch out. Let’s go through the risks.

the fed Failed to contain inflation because its “data-driven” policy looked backwards for too long, keeping interest rates too low for too long. By sticking to the data-driven mantra, it risks repeating the mistake in the opposite direction, increasing the likelihood of causing the next recession and having to do a 180. As the markets have only just begun to price in a recession and a fall in earnings, that would hurt.

On Wednesday, Fed Chair Jerome Powell went even further, saying he would not “declare victory” over inflation until inflation had been falling for months. Because inflation typically peaks at or after a recession begins, it is difficult for the Fed to stop tightening.

Mr. Powell talked about empirically finding out what level of interest rates is sufficiently slowing down the economy. I read that the Fed has pledged to keep hiking until something breaks.

The European central bank has a known issue: politics. On Wednesday, the ECB held an emergency meeting to address the problem of Italy and, to a lesser extent, Greece. The ECB is looking to dampen the rising heat on Italian bonds, where the 10-year yield rose to 2.48 percentage points above Germany’s before falling after the ECB’s action.

Unlike a decade ago, when then ECB chief and now Italian Prime Minister Mario Draghi vowed to do “whatever it takes,” the central bank has acted before a fire breaks out, which is commendable. But the interim measure to divert some of the maturing bonds bought as pandemic stimulus to struggling eurozone countries is relatively small.

The ECB promised to speed up work on a new “anti-fragmentation tool” as a long-term solution, but this is where it hits politics. The rich North has always demanded conditions on pumping money into troubled countries to ensure they don’t use lower bond yields as an excuse for more unsustainable loans. But until the flames engulf the economy, the stricken countries don’t want to face the embarrassment — and political disaster — of taking over oversight from the International Monetary Fund or the rest of Europe.

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It will be difficult for the ECB to buy bonds in Italy to keep yields low while raising rates elsewhere. At the very least, it must impose stricter policies on other countries than it otherwise would. In the worst case, it runs the existential risk that Italy will one day default, as Greece did, and the ECB’s own finances will crush it. Both are politically toxic.

At the moment the inflation problem in Europe is different than in the US as wages are not escalating. But if Europe follows the US, rates might have to rise so much that slow-growing Italy would struggle to pay interest on its sovereign debt, which amounts to 150% of gross domestic product, no matter how hard the ECB squeezes the Italian spread on German bonds .

Even a small risk of Italy getting into trouble justifies selling off its bonds as higher yields are self-fulfilling. When higher yields increase the risk of default, they make the bonds less attractive, not more attractive. Left to their own devices, the market would continue to spiral them higher.

The Bank of Japan is also struggling against the markets, although it has a better chance of winning than the ECB. Investors have bet the BoJ will be forced to raise its bond yield cap, known as yield curve control. In principle, the BoJ can buy unlimited amounts of bonds, so it can keep the cap if it so chooses. But if investors thought inflation warranted higher yields, the BoJ would have to buy more and more bonds because investors wouldn’t want them, the late economist said said Milton Friedman in 1968.

Japan has the best case for loose monetary policy of any major developed country. While inflation is above 2% for the first time since 2015, this is almost entirely due to higher global energy and food prices, and there is little push for higher wages. Exclude fresh food and energy, and annual inflation was 0.8% in April, little reason to panic.

Still, inflation has risen and there is a growing risk that the BoJ will have to soften, leading to a jump in bond yields – the kind of shift that can shake markets around the world. When the Swiss central bank lifted its currency cap in 2015, several hedge funds that had bet they would stick to their rates were hit hard, with some forced to close. Japan is many times more important than Switzerland, which itself roiled the FX markets last week with an unexpectedly hawkish rate hike that sent the franc sharply higher.

This gloom could be avoided – central banks are pretty smart. But bigger mistakes are more likely than they used to be, meaning the risk of extreme events in the markets is increasing. That warns investors to be careful.

Write to James Mackintosh at james.mackintosh@wsj.com

Navigating the Bear Market

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Luke Plunkett

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