Central banks and the markets: who’s guiding who?
Investors are deluding themselves if they believe central banks will always have their backs
Last week, European Central Bank (ECB) president Mario Draghi had a day he would rather forget.
At the ECB’s last press conference of the year on December 3, Draghi disappointed financial markets by announcing further measures to help stimulate the euro zone’s sluggish economic recovery that fell significantly short of investors’ expectations.
The euro had its best day since March 2009 (the opposite of what the ECB wanted to achieve in order to help lift the euro zone’s dangerously low inflation rate), the yield on Germany’s benchmark 10-year government bonds shot up 20 basis points – the sharpest one-day rise in four years – and euro zone equities slid more than 3 per cent.
Super Mario, as Draghi is often dubbed, was not so super after all.
Yet no sooner had sentiment deteriorated than Draghi once again lifted the spirits of investors by pledging, in a pre-arranged speech in New York, that there was no “limit” to what the ECB could do to meet its inflation target of 2 per cent. This helped weaken the euro somewhat and contributed to a rise in US equities as the monetary divergence trade – speculative bets associated with an anticipated rise in US interest rates and a further loosening in European monetary policy – was reaffirmed in the eyes of investors.
However Draghi’s “comeback”, in the words of the Financial Times, underscores the extent to which traders and investors are still hanging on central bankers’ every word, so much so that it is difficult to know whether markets are being led by central banks or, more worryingly, market reactions are determining the policies of central banks.
The Bank for International Settlements (BIS), the central bankers’ bank, is acutely aware of this risk and, in its latest quarterly report published on Sunday, pointed to the dangerous disconnect between investor sentiment (driven mainly by the policies of central banks) and underlying economic conditions which remain weak – particularly in emerging markets (EMs).
Claudio Borio, the head of the BIS’s monetary and economic department, cautions that “markets remain unusually sensitive to central banks’ every word and deed” and that “it is hard to imagine” how periods of calm in the markets can “be anything but uneasy”.
Examples of the tail wagging the dog – volatile market conditions that force central banks to provide further stimulus measures or delay the normalisation of policy – abound.
The most conspicuous one has been the dithering on the part of the US Federal Reserve ever since it terminated its asset-purchase programme in October last year and began preparing the ground for its first rate increase since 2006. The Fed’s concerns about deteriorating sentiment stemming from China’s woes prevented it from raising rates in September – even though investors themselves were prepared for (and indeed supportive of) a rate increase.
Not only did this prolong the uncertainty regarding the timing of the first rate increase – now almost certain to take place next week – it also heightened concerns that the Fed is being held captive by markets.
Another, more convincing, argument is that it is investors who have become beholden to central banks and are expecting far too much from the world’s leading monetary guardians.
Central banks have been guilty of raising expectations – with Draghi most at fault for having pledged, a mere fortnight before the ECB’s press conference last week, that Europe’s central bank would “do what [it] must to raise inflation as quickly as possible”, a promise which inevitably inflated hopes for more aggressive action. But, Bluebay Asset Management warned in a note, investors “have become conditioned to believe that central banks will always be ‘on their side’”.
Although unprecedented levels of quantitative easing – in the US, Europe and Japan – have sharply distorted asset prices, investors have got carried away, betting on further increases in prices in the face of weakening economic fundamentals.
The negative yields on the short-dated bonds of Italy – a country that was the epicentre of the euro zone crisis at the end of 2011, whose economy is barely growing and whose public debt stands at a crushing 135 per cent of GDP – throw the scale of mispricing in markets into sharp relief.
Central banks may be guilty of miscommunicating to markets. But investors are deluding themselves if they believe central banks will always have their backs.
Nicholas Spiro is managing director of Spiro Sovereign Strategy