Eight years since the banking system threatened collapse, financial markets are still dominated by central banks. Though macro fundamentals, and geopolitics, still have the capacity to influence flows, interest rates are largely being driven by the central banks’ actions.

Whether rates are being voluntarily controlled is debatable as, one by one, central banks have felt forced to embark on ‘unconventional’ journeys, pushing rates ever lower, and

creating other issues for both the machinations of the markets and for investors.

It is still too early to say whether they have got it right. The global economy has recovered from the lows in the aftermath of the financial crisis; growth has picked up in many regions and countries, and unemployment has fallen slightly, but economic growth is mediocre and below potential.  

With the US furthest in front in the economic cycle, having exhibited reasonable growth for the past few years, the Federal Reserve, unlike other central banks, has been preparing to begin withdrawing liquidity and to ‘normalise’ the interest rate environment. 

The Fed has repeatedly stressed that its actions are ‘data dependent’, but unfortunately its job, as well as the ability of the market to foretell its actions, seems to have become more difficult. 

US quarterly GDP growth (%)

For several years now, US economic data has been patchy and unconvincing, frequently sending signals that are at best unclear and sometimes conflicting. 

In today’s integrated global markets, however, the days when domestic conditions dominated the Fed’s actions and it was able to act as if in isolation are long gone. 

Many observers question how much Fed policy will be able to diametrically oppose that of the other major central banks. They argue that with the world still highly leveraged with mountains of debt, any removal of liquidity by the Fed could trigger a sharp, global, risk-off reaction, during which there would be few places to hide.


With rates in the major government bond markets still anchored, risky assets enjoyed a good summer as the lower volatility and the search for yield drove significant flows, producing handsome returns in hard and local currency emerging market bond markets. 

Fundamentals in many emerging markets have been improving, with GDP growth figures firming and industrial production picking up over the year, easing investment decisions to increase emerging market bond weightings. However, a difficult few months are in store. 

As well as the political events that look set to send volatility higher as autumn approaches, US Treasury yields will likely rise along the curve, should the Fed be perceived as hawkish, which would erode the spread offered by emerging market debt. The real worry is that the risks are skewed even more heavily to the downside as the world starts to face disappearing liquidity. 

In between the talk of ‘normalising’ interest rates, there has been discussion on what ‘normal’ means. It is generally accepted that the potential GDP growth rate (Y-star) of the US has been falling, and the medium term R-star (the natural rate of interest) is very low, not just in the US, and could stay persistently low. 

In an interesting study from the Federal Reserve Board of San Francisco*, its president John Williams argues that monetary policy “meets the boundaries of its influence” when challenged by the “obstructions posed by low R-star”. 

As he points out, “conventional monetary policy has less room to stimulate during an economic downturn owing to a lower bound on how low interest rates can go”. He argues that the burden should be shared with fiscal and other policies to aid economic stability, and to help solve the conundrum of how to deliver stable inflation in a low R-star world. 


A surprisingly more hawkish Fed will profoundly affect the currency markets, particularly in the emerging markets. For many Asian currencies the relative movements and stability of the renminbi will be key. 

After the turmoil of August 2015, the Chinese authorities have enjoyed managing the downward pressures on their currency. Although other market forces have been favourable, China deserves praise for working to clarify its policy motives, something it got wrong back in 2015, taking the markets by surprise, and for its measured interventions cushioning the downward trajectory.

Managing the ‘impossible trinity’ – maintaining a fixed exchange rate with capital controls and with monetary policy autonomy – was always a tall order. The goal for China, as recommended by the IMF, is to achieve a fully floating currency by 2018, which would mean removing one of the three incompatibles. 

China’s economic situation is complicated. Economic growth has been slowing, with some weak data over the summer, but the housing market appears immune, with buoyant sales and higher household borrowing adding to the risks of a housing bubble and the worryingly amount of leverage already in the economy. 

The relative stability of the dollar has been helpful. The dollar index is pretty much back to where it was in August 2015, having moved up and down only 2-3 percentage points in the intervening period. An aggressive renewal of the dollar bull market would create pressures for the renminbi.  

*Federal Reserve Bank of San Francisco, Economic Letter, Monetary Policy in a Low R-star world, John Williams, August 2016, www.frbsf.org 

Focus: Italy’s constitutional referendum

Interest in Italy’s approaching referendum on constitutional reform is moving centre stage. The reforms set out by the Renzi government have been met with approval by commentators, investors and other European politicians. The aims are to simplify and streamline its unwieldy political system by ending the bi-cameral system of Parliament and reducing the number of Senators from over 300 to 100.

Although the date has yet to be set, the vote must take place before 11 December. Opinion polls seem to be less prevalent in Italy, which does make it hard to gauge the mood, although it is obvious that they can be misleading. A ‘yes’ vote, which would secure change in Italian politics and strengthen Matteo Renzi’s position, is what investors would prefer. A rejection might result in his resignation, triggering another political crisis, and ending any hopes of keeping Italy’s reform agenda alive. It could also add to a sense of instability throughout Europe, particularly in those countries preparing for elections.

Back in 2015, when announcing the referendum, Renzi declared that should the people reject the reform proposals, he would resign. Perhaps becoming anxious about the outcome, perhaps taken aback by the UK premier’s hasty resignation after the Brexit referendum, Renzi has toned down his plans and may be backtracking on his bold earlier pronouncements. Whatever the outcome, this referendum will create volatility, and again there is the possibility that a feared tail risk will materialise.