Central Banks: the great illusion, for now … by A.D


Dear all,

It seems like nowadays, the most followed / most important market news are not anymore data (employment, GDP, inflation, corporate profits etc.) but rather speeches from Central Banks presidents.  And if I had to give an Oscar to the best of them, I would no doubt give it to Draghi as up until recently, he had managed to lift the markets without hardly spending any Euro so! The same cannot be said about Kuroda for instance. Fundamentals don’t matter so much anymore, or when they do, bad news (concerning the fundamentals) are actually good news for the markets as bad economic data represent a good reason for central banks to remain ultra-accommodative.

In this note I will go through the  actions of Central Banks since 2009, their impact of their decisions on markets and on the real economy, and try to explain how all this could end.

       1. Central Banks actions have gone all in!

Whether we talk about the Fed, the BOE, the ECB or the BoJ, I believe that it is fair to say that they have done everything they could to boost the economy. To a point where we can talk about a great experiment as such actions had never been taken in the past (if we take into account the volumes / size at stake). First, they have used conventional measures such as lowering interest rates. They have basically pushed interest rates to zero, and for a very long period of time. Looking at the Fed rates (see below), they have been close to zero for a period of 80 months! As a reference, the last time the Fed lowered interest rates (early 2000′), it kept them low for 39 months.

fredgraph (2)

Source: FRED

Similar actions were taken by the other Central Banks. Now, looking at unconventional measures, most Central Banks have engaged into Quantitative Easing (large scale purchase of securities – mostly, but not exclusively, government bonds). Those measures were taken in order to lower rates (cheap financing for governments, companies and household) and fight against deflation (by injection liquidities). See below the Fed’s balance sheet expansion over the last few years. It went from about USD 800bn to more than USD 4,400bn!


Source: FRED

And when one Central Bank decides to stop injection liquidities, another one decides to increase its asset purchase (like the BoJ just after the Fed decided to end QE3). See below the liquidity injections by the 4 main Central Banks since 2009.

central bank liquidity injections_0Source: BlackRock

The big question marks concerns the ECB. Draghi keeps saying that the ECB is ready to do more, and potentially launch a QE in order to fight against looming deflation in the Eurozone, but Germany is against it for now.

       2. Central Banks actions have been great for financial assets, not so good for the real economy

The impact of those liquidity injections and rate cut have been extremely positive for financial assets. Stocks are now at record highs (US, Germany etc.) , bond yields are at record lows besides weak fundamentals. the reason is quite obvious: with Central Banks buying massive volumes of government bonds, yields have gone much lower, which has led investors to invest in riskier assets (corporate bonds, high yield bonds, equities) in a search for higher yields. Also, cheap liquidities have flown into the financial markets, allowing them to inflate.

Here are 2 examples:

  • the impact of BoJ liquidity injections on the Nikkei since 2009

fredgraph (3)

Source: FRED

  • and the one of the Fed liquidity injections on the S&P

fredgraph (4)

Source: FRED

People who don’t see the correlation are either blind of not honest with themselves.

Similar impact has been seen on the bond market as well. If we take the example of Italy: it has been in recession for 16 consecutive quarters, debt to GDP is above 135%, but Italy is currently borrowing below 2% (10Y)! See the chart below.

fredgraph (5)

Source: FRED

Those liquidity injections have also had an impact of currencies, and the rules of the currency war are clear: the more aggressive wins. And the winner so far has been the JPY (trading at 117 against USD Vs below 80 a few years ago). The Euro has been weakening a lot recently as well, following the ECB’s QE announcement.

Central Banks actions have also had a great impact on some emerging market’s currencies. Indeed, when the Fed’s QEs were in place, many investors went to seek greater yields by investing in EM. That “hot money” then flew back (when the Fed announced the end of its QE) to developed countries which caused a severe drop in those EM’s currencies (Brazil, South Africa, Turkey etc.), and a rise in their bond yields, making financing conditions more expensive.

To summarize, Central banks’ liquidities have lifted the markets to new all time highs for most of them, besides weak fundamentals. Those market conditions have, however, mostly favored banks and individuals invested in the markets (therefore mostly the wealthiest).

       3. What’s next? 

While the market impacts of Central Banks actions have been overall very positive on markets, there is sadly no such thing as free lunch. Trying to fix debt issues with more debt should, unfortunately, have severe consequences in the coming years. Miracles do not exist in economic terms. Debt went from households to banks to governments to Central Banks. In theory, Central Banks could expand their balance sheet with no limit. But paper currencies are based on trust / confidence, on a promise that the piece of paper that you hold will be worth something in the future, will enable you to buy some goods etc. If we take the example of Japan, that has pushed this Central Bank’s exuberance to levels never seen before, the consequences should be severe and cause a sharp drop in the JPY. Who wants to hold assets based in a currency that might be worth much less in the future? Given the path that the BoJ has taken, it is very hard today to have any confidence in JPY. In economic terms, a sharp drop in a nation’s currency leads to higher import prices, which then causes inflation (not the “good inflation” resulting from strong economic growth, that leads to higher wages etc.) to increase and, in some cases, becoming uncontrollable.

There will also be consequences on the bond markets as investors will not be willing to buy government bonds of a nation that is destroying its currency. Even though the USD is pretty strong at present, China and other Treasuries’ holder have sharply slowed down their buying of Treasuries for this very specific reason. China did warn the Fed that this policy (balance sheet expansion) was not sustainable on the long term. And given the deficit that countries like Japan or the US have, they need foreign investors to buy their government bonds. If confidence is broken, then those countries will not be able to get enough external funding at a reasonable price, which will cause funding costs to rise, and the debt burden to become unbearable, which could ultimately cause some bankruptcies.

Central Banks have lost their independence and expanded their mandate (the ECB’s mandate was initially to control inflation only). They have become a major player in today’s economic and market environment and are finding themselves trapped in a corner with no possibility of escaping. Indeed, most economies are nowadays like a patient who needs more and more morphine to stay alive. If Central Banks pull the plugs, then the patient will surely die. Interest rates close to zero for such a long period of time, huge amount of liquidities flowing in the markets every day; this cannot be sustainable. Ultimately fundamentals will prevail, as they always have done in the past (unless “this time is different”?). Consequences should be severe market disruptions (bubbles always end up bursting) and bankruptcies. It is obviously too soon to assess the consequences of the actions that Central Banks have taken during the last few years, but I unfortunately cannot see this ending well. Let’s just hope that I am wrong!


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