Thursday 26 April 2018

Analysis: Markets are glued to every move made by Central Banks

Eugene Kiernan
Eugene Kiernan

Eugene Kiernan

Certainly as far as financial markets are concerned, central banks remain centre stage and every policy change or pronouncement can have a seismic impact on stock, bond and currency markets.

Global central banks have shepherded a modest recovery, starting with conventional policy moves on interest rates. In the US, the Federal Reserve began the avalanche down from 5pc in September 2007 in the face of the emerging financial crisis. Others followed suit - although the ECB did post one final increase in mid-2008.

Along the way, central banks have expanded their armoury to encompass more unconventional measures such as bond buying that we now regard as normal, and in some jurisdictions have made the move to negative interest rates. They have also sought to engage and communicate with markets to a level not seen before.

The ECB is now publishing the minutes of its meetings, while in the US, board members of the Federal Reserve keep up an active schedule of speeches and presentations.

It's difficult to recall that at one stage the Fed didn't even announce its rate changes - they had to be deduced by the markets.

Now we are facing into a period where central bank decisions are going to be pivotal for markets. On March 10, ECB President Mario Draghi will take the next steps in his bid to kick-start inflation in the Eurozone. The following week, the Fed has to walk a fine line as it may seek to leave rates unchanged without unnerving markets.

But increasingly the markets are raising the issue of central bank credibility which usually boils down to: is what they are doing working? If not, what else can they do; and do they have true conviction in their policies?

The reality is that central banks' policy objectives are long term by nature - usually around price stability and full employment. Some central bank mandates also refer to financial stability and in other cases it is implicit. It is clear that while markets look to central banks, central bank policy makers are also playing close attention to markets, and how they might respond to decisions.

In the US last September, the Fed pulled back from a rate hike in the face of what it termed global uncertainty. Subsequent testimony showed that this is still a consideration. Should central banks be so sensitive to short term market concerns? It is hard to imagine Paul Volcker, the chief of the US Fed in the early '80s as he strove to "whip inflation now", which necessitated huge spikes in interest rates, being as successful as he was, if he was in tow to short-term market moves. It's tough to envision Volcker ever using a phrase such as "data dependent" in his policy reviews! Central banks aim to be transparent. In the US, members of the Federal Reserve Board give their views of the most likely path of rates, (the so-called "dot-plot"). Yet since they began this practice, the market has consistently had a different view and certainly in this cycle the market's view has won out. It doesn't help that the head of the Federal Reserve's enthusiasm for the "dot-plot" tends to wax and wane.

Financial markets have become dependent on, if not addicted to, the measure and moods of our central banks. Speeches are parsed, policies analysed to the nth degree and for some analysts, what lies beneath is a lessening confidence in the power of central banks to achieve their real economic objectives. Economies are out of intensive care but by no means in robust health. Over the past seven years or so, we have seen huge moves in asset prices such as equities, bonds and property but little sign of a resurgent consumer or the pick-up in inflation to signify a more vibrant economy.

To date, global central bank policy can be argued to have staved off the worst and stabilised economies, but certainly hasn't unleashed any animal spirits in terms of consumption or capital expenditure. Coupled with this, we've had some degree of (financial) collateral damage. There have been side-effects from the treatment administered which don't necessarily help the overall objectives of financial stability. Ultra-low bond yields have led to rising pension liabilities, which in some cases overwhelm corporate balance sheets.

Moves toward negative interest rates lessen banks' ability to grow their way back to more resilient capital ratios.

The anaesthetic impact of QE on asset classes such as bonds may be blinding investors to a truer appreciation of the risks either fundamental or technical. These may seem a side issue but the longer we stay in a "sub-par" growth world the larger they loom.

Unconventional policy has costs as well as benefits.

Eugene Kiernan is head of investment strategy at Appian Asset Management, which is regulated by the Central bank of Ireland. The views expressed do not constitute investment advice.

Irish Independent

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