There’s never been a time in history where participants have looked to central banks for guidance like now. It’s no secret markets look to these institutions to better understand the macro/fundamental outlook, and health, of a country’s economy and the global financial system.
In this article we will ask whether the Central Banks have gone too far; and dare we say it – question:
Do they really know what they’re doing?
Before we dig deeper, let’s first examine the current environment and briefly discuss how we got here.
The current environment
The current environment began back in 2008 when the GFC became real. Here – central banks led by the FED entered uncharted waters. First we saw large-scale bailouts, followed by QE (Quantitative Easing). Additional rounds of QE saw other parts of the world follow.
Then what economists previously thought was impossible very quickly became a reality: Negative Interest Rates.
Over in Europe and Japan (with negative rates) we are constantly being told things are fragile. The US- which ‘appears’ to have far better fundamentals, has yet to make the most of these factors. Market sell-offs have been very sharp (but in fairness- short-lived)- and to a certain extent there is still plenty of uncertainty around the world.
Since 2008, institutions (and regulatory changes) have made efforts to avoid another financial crisis. In doing so – they have ‘muted’ the financial system by discouraging lending, reducing liquidity and placing stricter requirements on available capital.
Recently – much of the uncertainty has come from the central banks themselves – primarily through the use of unconventional methods. Traditionally – many would argue that central banks seek stability through a conventional and conservative to monetary policy.
What we have seen since the GFC (and particularly this year) has been far from that…
Are they all the same?
It should be said that whilst many central banks have a similar mandate towards increasing inflation – not all Central Banks share the same views on monetary policy.
For example:
The US Fed has been very patient as of late, and avoided any need to raise rates. They have made it very clear their decision will be ‘data-driven’, and will not move on interest rates until their data deems appropriate.
Like the Fed – the Bank of England was just earlier this year looking at the prospect of raising rates (for the first time in 7 years!). However with the onset of Brexit, we saw a complete backflip as they actually reduced rates!
In Europe – the ECB is committed to doing whatever it takes to help the Eurozone…
And in Japan – BoJ Governor Kuroda believes ‘there is no limit’ to monetary policy!
In other parts of the world things are very different too.
The Swedish Riksbank got things seriously wrong when they raised interest rates in 2010-2011, and of course the Swiss National Bank abandoning its exchange rate peg in 2015 was the worst decision we have seen to date.
But with all this divergent monetary policy – one thing remains common with many central banks: Inflation (or the lack of it).
One target for all – 2% inflation
Over the course of this year, central banks have been committed to a particular mandate- ‘the inflation target for price stability’.
However, markets are now beginning to question – should the central banks be pursuing stable prices, and acting as a lender of last resort, instead of seeking a stable rate of inflation…?
One such way in which Central Banks have tried to achieve this is through QE. We have previously spoken about QE – and how it has been beneficial for stockmarkets. With QE – central banks create liquidity which force buyers back into the stock market.
However there is a big elephant in the room here:
What if the economy and all the assets we trade do not ‘inflate’ and grow into their valuations? In other words: What if the effect of QE (designed to create liquidity, and in-turn inflate prices) quickly disappears?
Then we have a problem..
The Issue
At present – we’re seeing central banks purchasing assets at record rates.
The SNB and BoJ are both large owners of stocks, and corporations are buying back record levels of stocks. This is important as the players who are inflating the prices of stockmarkets are not the same as previous bull markets.
More importantly – these participants are driven by different motivations than the traditional institutions and investors looking for positive returns.
In addition to adding liquidity – central banks are also purchasing stocks and bonds in order to ‘monetise’ government debt.
You may be asking: Why is any of this important or relevant to me. Well quite simply the markets are changing before your eyes. And this can have a serious impact on your trading systems!
The actions of central banks right now are very important. Many would argue there is no reason why a central bank should own stocks or companies. Following their stock and ETF purchases, will central banks find a way to purchase corporate bonds or other asset classes…?
And how far will some of these banks devalue their currencies..?
Remember what we previously thought was impossible is now happening. So who is to say we won’t see more involvement from central banks…?
Which leads us to what we think might be the bigger issue: Faith and Trust.
Central Banks are knowledgeable and powerful, so they must be right
Herein lies the tremendous risk.
The trust and faith markets put in Central Banks has all but reached an extreme – hence the purpose of this article.
With so many looking to the FED, the ECB, BoJ and others for guidance, have you ever considered: what if they get it wrong like the Swedish and Swiss National Banks did?
It would be a disaster.
It is this blend of faith, trust and power that central banks hold that potentially make them the most financially dangerous institutions around the globe.
Whilst they may have good intentions – are they aware of the long-term consequences?
Again – since the GFC, central banks have brought in measures in order to fix the economy. However – we are starting to see that their actions have not come to fruition as expected.
Mark Carney (Governor of the Bank of England) has summed it up best: “For the past seven years, growth has serially disappointed… It is a reminder that demand stimulus on its own can do little to counteract longer term forces…”
Perhaps the central bank of all central banks – the BIS (Bank for International Settlements) summed it up best – when they noted their concern for how financial markets depend on central bank policies.
Are Central Banks the new ‘too big too fail’?
We have written in the past that this bull market in world stock markets may not be over just yet, more uncertainty, and perhaps another crisis (mini-crisis?) is not unlikely. And there is every chance such a crisis may stem from a central bank monetary policy gone wrong.
Since the GFC – central banks (led by the FED) have restored market confidence by providing liquidity, and easing interest rates. Whilst we have seen higher stock prices and less volatility, there has been no increase in productivity or inflation growth.
Another potential issue were the regulations introduced post GFC. The “Too Big to Fail” issue is still a concern today.
So is it time to question: Are central banks helping markets, or destroying price mechanisms and stability?
According to multiple sources (Bloomberg, CNBC, WSJ) – a third of the worlds government bonds are now yielding negative rates (close to $12 trillion!)
Whilst we continue to hear that all is still fine – we are simply pointing out these may be serious fundamental issues worth paying attention too.
Summary
With each meeting, traders are questioning the actions of central banks.
As the currency wars continue to play out, we are mindful that if enough participants believe in central banks, they may just become a self-fulfilling prophecy.
An example of this is QE:
Many believe that QE works because QE works. If QE doesn’t work, more QE is needed because QE works! What we’re referring to here is a self-fulfilling prophecy that markets act upon through belief, trust and faith in central banks.
Remember – what was previously unthinkable has now become the new normal.
At present – central banks have not lost credibility amongst the public. But if this public confidence is shaken- we may have a serious problem with longer-term consequences.
As traders – you may have heard the saying- “Don’t fight the Fed”.
We are now posing the question: Is the Fed bigger than the market…….?
