How interest rates and central bank tea leaves will determine the financial weather forecast for 2018
Andrew Sheng says monetary policy set by the leading central banks, not unseen economic forces, will be crucial in 2018
All markets function on a heady mix of greed and fear. When the markets are bullish, the investors know no fear and regulators think they walk on water. When fear grips the markets, all eyes are on the central banks. The year 2017 was one of smooth tailwinds, even though everyone was mesmerised by the Donald Trump reality show. Heading into 2018, one issue on everyone’s minds is whether headwinds will finally catch up.
Last week, US Federal Reserve Bank vice-chairman Randal Quarles was visibly confident about the US economy. Real gross domestic product growth through the final three-quarters of 2017 averaged almost 3 per cent, faster than the 2 per cent average annual pace recorded over the previous eight years. The European recovery, barring Brexit, looked just as rosy. Euro-zone growth has stepped up to 2.7 per cent in 2017, with inflation at around 1.2 per cent and unemployment down to 8.7 per cent, the lowest in the region since January 2009.
In Asia, China’s GDP grew by 6.9 per cent in 2017. With per capita GDP reaching US$8,836, China is expected to reach advanced country status by 2022. Meanwhile, the Indian economy may overtake China in growth speed in 2018, with an estimated rate of 7.4 per cent. The IMF’s World Economic Outlook for 2018 sees growth firming up across the board.
Having climbed almost without pause in most of 2017 to January 2018, the financial markets skidded in the first week of February. On February 5, the Dow Jones Industrial Average plunged 1,175 points, the biggest point drop in history. However, the index has rebounded about 9 per cent in the past fortnight. Losses in Wall Street resulted in profit-taking in other markets.
Will headwinds disrupt the market this year or will there be tailwinds as economic forecasts suggest? What makes the reading for 2018 difficult is that the buoyant stock market (and weakish bond market) is driven less by the real economy than by the loose monetary policy of the leading central banks. With clearer signs of recovery, central banks are hinting at interest rate hikes. The projected three Fed interest rates hikes in 2018 augur negatively for stock markets and worse for bond markets. While the Bank of England and the Fed are on the hawkish side, the European Central Bank is divided and the Bank of Japan will continue with quantitative easing.
The divided stance facing the ECB is interesting. In his latest statement to the European Parliament, ECB President Mario Draghi reaffirmed that the euro area economy is expanding robustly. Because inflation appears subdued, although wage growth has picked up, he argued that “patience and persistence with respect to monetary policy is still needed”. In an unusually critical article last month, Jurgen Stark, former ECB board members and deputy president of the Bundesbank, called the ECB “irresponsible”, saying that its refusal to normalise policy faster increases the risks to financial stability. In short, the bigger partners in Europe think tightening is the right way to go.
If both central banks begin to reverse their loose monetary policy, liquidity will become tighter and interest rates will rise. Financial markets have therefore good reason to be nervous. After 2014, when markets fell on the fear of the Fed unwinding too fast, central bankers are particularly aware that they are walking a tightrope. If they reverse too fast, markets will fall and they will be blamed. If they are too slow, the economy could overheat and inflation will return with a vengeance, subjecting them to more blame.
In the meantime, trillions in liquid funds are waiting on the sidelines to bet on market recovery at the next dip. But this time, it is not the market’s invisible hand, but visible central bank policies that may pull the trigger. Man-made policies will always be subject to fickle politics. The fear is that, once the market drops, it won’t stop unless the central banks bail everyone out again. This means that central bankers are still caught in their own liquidity trap. Damned if they tighten, and damned by inflation if they don’t.There are no clear tailwinds or headwinds in 2018 – only lots of uncertain turbulence and murky central bank tea leaves.
Andrew Sheng is Distinguished Fellow, Asia Global Institute, at the University of Hong Kong