Fear returns as markets suffer blows

It has been clear right through this year that bond markets had major doubts about the durability and strength of the recovery in the world economy.

This is evidenced by the decline in bond yield everywhere since the start of the year, despite the US Federal Reserve winding down its QE programme and the US and UK central banks both hinting at rate rises from next year.

Equity markets, though, have been more positive, boosted by good data in some economies like the US and UK.

Low interest rates and further easing by the ECB have also helped sentiment in stock markets.

However, tensions which had been building in the markets over the past month finally exploded last week.

There was a flight to quality into the major bond markets. Equities suffered large falls, although they subsequently recovered some lost ground.

There was damage elsewhere too.

Oil prices plunged further, while the VIX index, or so called Wall St fear index that gauges market volatility, rose to its highest level since 2011.

Meantime, the dollar rally of recent months came to an end.

It really was a perfect storm that hit financial markets last week.

We saw a downbeat assessment of the global economy from the IMF, some soft data in the US and UK, very weak, recession-type figures from the eurozone and a further plunge in oil prices that added to deflation fears.

On top of this, there were some disappointing third-quarter corporate earnings results in the US, a re-emergence of upward pressure on Greek bond yields, rising geopolitical risks from ebola to unrest in Hong Kong, while the Fed and Bank of England have started expressing some doubts about rate hikes next year.

This has all happened at a time when the Fed is terminating its QE programme. Markets in the end took fright, having enough of the low volatility that characterised trading for much of 2014.

Stocks crumbled as risk aversion and fear took hold.

There has also been a major change in market expectations in regard to rate hikes in the US and UK.

The timing of the first US rate hike has been pushed back to later in 2015. Futures contracts now see UK and US rates rising to 1.25-1.5% by end 2016 compared to 2% or above, previously.

Ironically, the plunge in energy prices and long term interest rates should provide support for the global economy.

This could increase the dilemma facing central banks like the Fed and Bank of England.

Unemployment rates have fallen to around 6% in both the US and UK, while their economies are growingstrongly.

The question facing their respective central banks is whether extremely low official interest rates should be raised in response, given the very low inflation environment and fragility of the recovery in the global economy.

Meantime, the question for the ECB is whether it needs to loosen policy even further, with the eurozone facing the growing risk of deflation and a triple-dip recession.

A bigger question, though, is whether monetary policy is losing its effectiveness.

There are real concerns that the world economy may have entered a prolonged period of low inflation and weak growth, reflecting structural rather than cyclical factors.

These include, ageing populations and slow labour force growth in many developed economies, as well as a slowdown in technological advancement and thus weaker productivity growth.

On top of this, the legacies of the 2008-09 financial crash, including much tighter credit conditions and prolonged deleveraging to reduce high debt levels, are also dampening growth. Meantime, we may be at the end of the phase of rapid growth in emerging economies.

If weak growth and low inflation is the new paradigm, there is little monetary policy can do to change it. Interest rates, though, will remain low for a very long time.