Jury’s out on central banks’ resolve to face down markets
Is the new US Federal Reserve chairman Powell the bold policymaker long sought by the Bank for International Settlements?
For the last several years, the Bank for International Settlements (BIS), the so-called central bankers’ bank, has repeatedly warned the world’s main central banks of the dangers of delaying their exit from years of ultra-loose monetary policy.
As far back as June 2014, the BIS said central banks were being too “hesitant” to remove stimulus “out of concerns about disrupting [financial] markets” and that “the risk of normalising [policy] too late and too gradually should not be underestimated.”
Last week, Jerome Powell – the bold new chairman of the US Federal Reserve – who unlike the last three chairs is not an academic economist and has extensive experience working in the private sector, gave the strongest hint yet by a leading central banker that rising volatility in markets is not a sufficient reason to refrain from withdrawing stimulus.
Indeed not only did the new Fed chair strike a distinctly hawkish tone in his testimony to Congress last Tuesday, he signalled that stronger data on growth and inflation strengthen the case for a faster pace of interest rate rises than markets are currently pricing in.
The “Powell effect” is already palpable in the Fed Funds futures market, contracts that reflect market views of where US rates will be at the time the contracts expire.
The odds of four or more rate rises this year – one more than the Fed currently anticipates – has shot up to 35 per cent, its highest level on record.
Powell is not the only prominent central banker who appears willing to test the resilience of stimulus-dependent markets more forcefully than has been the case up until now.
Last Friday, Haruhiko Kuroda, the governor of the Bank of Japan, surprised international investors by announcing for the first time a date (April 2019) for the start of a debate over how to unwind the BoJ’s aggressive quantitative easing programme provided the central bank’s 2 per cent inflation target is met.
The European Central Bank (ECB), for its part, is preparing for a showdown with markets when it ends its asset purchases in September and begins to normalise policy.
For the first time since the end of the global financial crisis, the so-called “central bank put” – the long-held belief on the part of traders and investors that leading central banks can be relied on to stabilise markets during periods of turmoil, effectively acting as circuit-breakers for financial stress – is being called into question.
In a note last week, Bank of America Merrill Lynch warned of a regime change in markets this year: “the central bank ‘liquidity supernova’, the primary driver of [markets] for the past 9 years, will peak in 2018: central bank purchases of US$4 trillion in the past two years will shrink to $0.4 trillion in 2018”.
Yet the moment of truth between central banks and markets is still a way off – and may prove less climactic than many expect.
While Powell may have signalled in his testimony last week that the Fed will be more tolerant of financial volatility, the jury is still out on whether the main central banks, in particular the ECB, will be willing to remove stimulus in the face of a much sharper and more prolonged sell-off than the one that occurred nearly a month ago.
The draining of the quantitative easing (QE) punchbowl has barely begun and financial conditions remain loose despite the recent rise in bond yields.
As I explained in a previous column, it is unclear how the end of the global QE era will affect asset prices, partly because of the sheer scale of monetary accommodation over the past decade but also because of structural and technological factors that continue to suppress bond yields and inflation.
One of the most important determinants of central banks’ resolve to remove stimulus, and the litmus test of how investors will respond to the end of QE, is the shift to tighter policy in Europe.
Not only have the ECB’s asset purchases and negative rates shored up the euro zone economy for the last six years, Europe accounts for over a third of the global stock of negative-yielding government and corporate bonds, according to data from JPMorgan, with Japan making up the rest.
Make no mistake, it is the willingness of ECB president Mario Draghi – and that of his successor, once Draghi’s term expires next year – to face down markets by tightening policy which will be the real test of central bankers’ mettle.
Powell may prove to be more hawkish than markets anticipate, yet the concerns of the BIS are likely to lie more with Europe’s central bank.
Nicholas Spiro is a partner at Lauressa Advisory