Markets’ fixation on central banks has gone too far
Ever since the global financial crisis, monetary policy has become the overriding determinant of market sentiment
Another week, another burst of market commentary about the policy intentions of the world’s leading central banks.
On Monday, investment strategists were falling over themselves to talk up the prospects of continued monetary stimulus in Japan following the emphatic victory of premier Shinzo Abe’s ruling Liberal Democratic Party-led coalition in Sunday’s parliamentary election.
Abe’s win provides a fillip to his three-pronged reflationary economic plan, dubbed “Abenomics”, whose most important plank in the eyes of international investors is the aggressive quantitative easing (QE) programme the Bank of Japan has pursued since April 2013. The yen, which has plunged nearly 17 per cent against the dollar since the BOJ embarked on QE, has fallen to its weakest level in over three months while the Nikkei 225, Japan’s main equity index, rose for a 16th straight day on Tuesday, its longest winning streak since 1950.
Abe’s win makes it more likely that BOJ governor Haruhiko Kuroda will be reappointed when his term ends next April and, more importantly, that Japan will remain a crucial source of liquidity for the global economy as the Federal Reserve and the European Central Bank withdraw (or prepare to reduce) stimulus.
Yet, is the divergence in monetary policy between the BOJ and its US and European counterparts as stark as central bank watchers claim, and are investors reading too much into shifts in policy?
Ever since the global financial crisis erupted, investors have been fixated on central banks. Monetary policy has become the overriding determinant of market sentiment, so much so that QE has cast a spell over markets, anaesthetising investors to a plethora of vulnerabilities in the financial system but at the same time making them hypersensitive to even the slightest change in tone by a major central bank.
Make no mistake, there is only one thing that markets truly care about: monetary policy.
This is not surprising given the pervasive influence of ultra-loose monetary policies on asset prices. According to Deutsche Bank, the world’s four leading central banks – which include the Bank of England – now own a combined US$14 trillion of assets, more than the annual output of China, the world’s second-largest economy. This massive and unprecedented dose of stimulus has driven up the prices of bonds and equities to record high levels, fuelling fears – bordering on paranoia – among investors about the consequences of a removal of stimulus.
Markets have been hanging on central bankers’ every word since the Fed’s unexpected decision in 2013 to begin scaling back its asset purchases, a move that triggered a disorderly sell-off and forced the bond market’s “stimulus junkies” to reconcile themselves to a post-QE world. When other leading central banks, in particular the ECB, began to sound more hawkish, investors’ fixation with central banks reached new heights.
Markets are now speculating frantically about which central bank is likely to tilt the most in a hawkish direction.
Yet these bets change from one day to the next, showing just how uncertain investors are about the intentions of central banks – who themselves are unclear about their future policy stance.
The consensus in markets is that the Fed is furthest down the road of policy normalisation. Reports that US president Donald Trump is favouring John Taylor, widely viewed as a hawk, to replace Janet Yellen as Fed chair when her term expires in February are reinforcing the perception that the Fed will tighten policy the most.
Yet investors are downplaying the small matter of inflation – which is still significantly below the Fed’s 2 per cent target – and the near certainty that whoever becomes the next Fed chair (Yellen could yet be reappointed) will tighten policy in a gradual manner.
The Fed may not be as far down the path of tightening as many expect.
Investors may have also misread the ECB. On Thursday, Europe’s central bank will lay out plans to begin scaling back, or “tapering”, its asset purchases, probably by announcing that it will buy fewer bonds in order to extend QE to the end of next year. This “dovish taper” is likely to convince investors that, unlike the Fed, the ECB has no plans to raise interest rates any time soon.
By the end of this week, the ECB’s policy stance may be closer to the ultra-dovish BoJ’s than the increasingly hawkish Fed’s, forcing investors to revise their assumptions about monetary policy yet again.
Perhaps this will convince market participants to stop obsessing over central banks’ every move.
Nicholas Spiro is a partner at Lauressa Advisory