Markets hungry for next monetary fix
Call it monetary morphine. The market has become addicted to receiving regular doses of help from central banks.
Be it quantitative easing by the US Federal Reserve and Bank of England or the European Central Bank’s bond-buying and cheap loans for banks, risky assets such as equities have responded positively to any support over the past four years even if the sugar high has eventually worn off.
But this week has been rather revealing as all three western central banks have refused to provide extra stimulus, at least for now. Equities have still rallied with the S&P 500 up about 4 per cent on the week after coming close to touching its lowest point of the year last Friday. It all had the air of a “phoney war” as one analyst described it.
Many investors are sceptical about the benefits of more action by monetary authorities, especially as government bond yields – the main tool used by the central banks – have all recently touched historic lows.
“If you look at the last couple of years, central bank intervention in the US has led to improvement in risk assets but it has then fizzled out … In the US, and UK, there probably are diminishing returns to QE for asset markets,” says Andrew Balls, head of European portfolio management at Pimco, one of the world’s largest bond fund managers.
But monetary morphine was provided to the markets this week, and from an unexpected quarter: the People’s Bank of China on Thursday cut interest rates for the first time in four years.
For some optimists, this suggests that central banks in emerging markets – where official interest rates are generally much higher than the record lows at the Fed, Bank of England and ECB – still have the ability to support the global economy if necessary.
But for pessimists – who can point to falls in nearly all Asian markets on Friday – the move is potentially alarming as it underlines how worried Beijing is about slowing growth.
“My sense is that the action is consistent with a more concerted effort by policy makers to address the deteriorating growth outlook in China,” says Nicholas Ferres of Eastspring Investments, one of Asia’s largest asset managers.
“The series of policy changes over the past few weeks suggests to me that a meaningful shift towards more accommodative policy has taken place,” he adds.
Frederic Neumann, Asia economist at HSBC, is more cautious, warning not to expect big rate cuts across the region. He says markets are pricing in cuts in most Asian economies but rates are already at lower levels than before the collapse of Lehman Brothers in 2008.
“Central bankers in Asia have grappled for the past few years with the effects of overly loose monetary conditions. Easing policy further, even if it provides a little relief in the short term, could provide even bigger headaches later on,” he adds.
A Hong Kong-based hedge fund manager goes further, saying: “For them to cut rates the way they did, they’re showing panic. It means the growth numbers are coming in way lower than they were expecting.”
He believes that some assets could benefit in the short to medium-term but warns: “Long term, there are no real winners here.”
Most investors, however, believe for any bigger kick to riskier assets western central banks need to act. Mr Ferres says Friday’s price action in equities and gold shows how “the market is craving for policy easing from the ECB and the Fed as well”.
And for many in the markets it is the ECB that has the main power to surprise and give markets a new shot in the arm. Mario Draghi, the ECB’s president, said the central bank stood ready to act but underlined it could not compensate for “other institutions’ lack of action”, hinting that it was for governments to act first.
Mr Balls argues that the ECB is in a different position to the Fed and Bank of England. “There is a huge difference between the European situation and the US situation. The European situation is very different: the ECB can be very potent if it wants to be,” he says.
That is because its main recent policy tool has been the longer-term refinancing operations, known as LTROs, under which it has extended cheap loans to banks in return for collateral. Proper QE would involve it buying the bonds of countries such as Spain and Italy in massive size, a course advocated by many investors.
Another possibility would be for co-ordinated action among central banks such as the October 2008 rate cut by seven central banks. But this week has shown that is not yet on the agenda. “One thing you don’t have with all these disparate acts is a level of coordination. A properly coordinated response – that could be quite powerful,” says Mr Balls.
That leaves investors worried both about going cold turkey and the efficacy of a new shot in the arm. Either way, the recent rally in stocks appears to be on shaky foundations.