The past few years have been characterised by a widespread loosening of monetary policy in many countries to counteract very weak inflation and sluggish economic growth.
Interest rates have been lowered to historically low levels, with central banks also adopting non-standard measures, such as quantitative easing (QE).
Meanwhile, there has been a marked scaling back of rate hike expectations in economies where policy tightening had been expected to commence.
These trends have continued in 2016. The Bank of Japan stunned markets in January by unexpectedly cutting rates, moving them into negative territory.
The ECB eased policy further at its March meeting, lowering the deposit rate by a further 10 basis points to -0.4%, while also expanding its QE programme.
The Bank of China has also loosened policy further this year, while the reserve banks of Australia and New Zealand cut rates over the summer.
The Bank of England has become the latest central bank to ease policy, following the vote by the UK to leave the EU. It cut the bank rate by 25bps to 0.25% and expanded its QE programme.
Indeed, the outcome of the UK’s EU referendum has had a major impact on interest rate markets. The vote in favour of Brexit has increased uncertainty about the outlook for the global economy.
Many of the world’s main central banks retain a clear easing bias and could well loosen policy even further in the coming months.
This has seen markets become even more relaxed about interest rates, expecting them to remain very low for an even longer period of time. As a result, bond yields have fallen to very low levels, with more and more bonds carrying a negative yield.
Meanwhile, after raising rates by 25bps to 0.375% at its December 2015 meeting, the first such rate hike in nearly a decade, the US Federal Reserve has refrained from any further rate hikes since then.
This has been, in part, due to financial market volatility and some unexpected softness in the US economy in the first half of 2016.
However, the Fed retains a tightening bias. It has been indicating for quite some time that it is likely to steadily increase rates over the next couple of years.
Markets, though, are quite sceptical because of its inaction to date. Thus, they are expecting just two 25bps rate increases between now and the end of 2018, implying US rates would remain below 1%.
The extraordinarily loose global monetary conditions, reflecting either near zero or negative interest rates and large-scale QE, or asset purchase programmes by central banks, are driving financial markets to quite elevated levels.
As already indicated, bond yields in many markets have fallen to exceptionally low levels. Credit spreads have tightened considerably.
Investors are being forced to move into riskier asset classes in search of higher yields, including emerging markets, which have seen a pick-up in capital inflows this year.
Meanwhile, most stock markets are performing strongly. The S&P 500 in the US is at an all-time high, with its price-to-earnings ratio at historically high levels also.
A key reason is that equities look attractive as an asset class compared to the very low yields available on bonds.
It is not just the low interest rates that are pushing markets to elevated levels but also the expectation that this benign interest rate environment will last for many years.
Money market rates in the eurozone are not expected to turn positive again until 2021. US rates are not expected to hit 1% until 2019. It is expected to be 2021 before UK rates rise to 0.5%.
Obviously, any change to this benign rate outlook would create havoc on financial markets. The most likely catalyst would seem to be a pick-up in US inflation.
The Fed has kept rates very low on the view that inflation will remain subdued despite the fall in the US unemployment rate to under 5%.
If the Fed is wrong on this, US rates would have to rise sharply, causing turmoil on markets.
Hence, investors should pay close attention to indicators of wage growth and core inflation in the US for any signs of upward pressure on prices.
Oliver Mangan is chief economist at AIB
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