Introduction to the Maradona Theory
The FIFA World Cup is set to return to Mexico, alongside the US and Canada, this summer. This event brings back memories of Diego Maradona’s legendary goal against England in the World Cup quarter final in Mexico almost 40 years ago. Maradona’s legacy extends beyond the football field, with his name being used to describe a theory in monetary policy. Former Bank of England Governor Mervyn King coined the ‘Maradona theory of interest rates’ in a speech back in 2005.
What is the Maradona Theory?
The Maradona theory refers to the way central banks use forward guidance to influence market expectations. According to King, Maradona’s goal appeared to involve dribbling around half of the England team and the goalkeeper, but in reality, he ran in almost a straight line. He beat the defenders by feinting to the left and right, but instead went directly towards the goal. Similarly, central banks can indicate that they may hike rates in the future, causing markets to react by pricing in hikes and shifting longer-term borrowing costs for consumers and businesses higher. This serves as a tightening in financial conditions, slowing growth and lowering inflation, without the central bank actually changing direction.
Success of the Maradona Theory
Central banks have had success applying the Maradona theory over the past two decades. Forward guidance kept yields low after the 2008 financial crisis and again after Covid. However, as a bond fund manager, it’s essential to determine whether central banks truly intend to follow through on their suggestions or if it’s just a feint to get markets to do their work for them.
European Central Banks’ Messaging
The messaging from some European central banks seems suspect. The Bank of England cut interest rates in December, and Governor Andrew Bailey switched from voting for a hold to a 25bps cut. Following the UK Budget, the Bank of England assumes UK inflation will be close to 2% from April next year. However, the labour market has been steadily deteriorating, and the Bank of England acknowledged this. The ECB has revised up its growth forecast, and eurozone bond yields have jumped sharply higher, with markets pricing in an ECB hike about a year from now.
Implications for the Economy
The stronger euro and jump higher in eurozone bond yields will serve as a substantial drag on future economic activity. This will slow growth and make future rate hikes less likely. As a result, we’ve been moving longer of rate duration in Europe recently. Additionally, if the Bank of England rate setters use their hands to move rates low to achieve their inflation goal, the pound sterling could substantially weaken.
Conclusion
In conclusion, the Maradona theory of interest rates is a powerful tool used by central banks to influence market expectations. While it has been successful in the past, it’s crucial to determine whether central banks’ forward guidance is credible. The current messaging from European central banks seems suspect, and we’ve been adjusting our investments accordingly. As the economy continues to evolve, it’s essential to stay vigilant and adapt to changes in central bank policies and market expectations.
