Inflation surge could puncture the asset boom, warn financiers

THE world financial system is moving towards a dangerous “inflexion point” as inflation rears its ugly head, risking a surge in interest rates and a violent shock to the edifice of asset prices.

“We’re moving into difficult territory. Inflation could be the big surprise of this year,” said Axel Weber, chairman of UBS and ex-bundesbank head.

Mr Weber said central banks are coping with the aftermath of an unprecedented monetary experiment that they do not fully understand and the reversal of emergency policies may be much harder to handle.

“At some point the inflexion point will come,” he said at the World Economic Forum in Davos.

Ray Dalio, the founder of Bridgewater, said a surprise surge in rates at this late stage of the cycle would puncture the boom and set off an abrupt repricing of the global asset universe. Stretched durations in the bond markets imply that even a modest rise in the long-term rates could lead to trillions of dollars of losses.

“The sensitivity to a rate change is greater than before. It is very high,” he said, warning the US is hitting capacity constraints and risks overheating. The Trump tax cuts are juicing the economy at the wrong moment. “A weaker dollar adds more stimulus. We’re adding stimulus on stimulus,” he said.

Mr Weber said the traditional “credit channel” mechanism of monetary policy shut down when interest rates collapsed to zero during the post-lehman slump. Quantitative easing lifted the economy through a different mechanism, by boosting financial markets – a wealth effect from gains in equities, bonds and property. People have been lulled into complacency, forgetting what will happen when normal conditions return.

“We’re now switching back on the credit and interest rate channel. I would not be sure that central banks can manage this,” he said.

The prospect of liquidity seizure on the vast offshore dollar funding markets – without the Fed standing ready to uphold the international system – terrifies veteran officials, even if it receives little wider attention.

Benoît Coeuré, a member of the European Central Bank’s executive board, said: “You need a lot of trust, if you wish to avoid an accident,” he said.

The worry is that global debt levels have jumped by 51 percentage points to a record 327pc of GDP since the Lehman Brothers crisis, so the system is essentially more fragile.

“The real issue is how we are going to end this cycle. Can we have a soft landing?” asked Min Zhu, the former deputy chief of the IMF and the People’s Bank of China.

Mr Coeuré inadvertently underscored the dangers of reversing QE when he described how powerful it had been. “It has had a very strong impact,” he said. If so, its removal may not be as smooth as banks like to suggest.

Mr Dalio summed up the pervasive worry of Davos veterans as the global expansion nears old age: the authorities have run out of monetary and fiscal ammunition if anything goes wrong, and the fragile societies may start to crack in another economic downturn. “It won’t be a pretty picture,” he said.