What if central banks don’t matter?

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Global financial markets continue to digest the People’s Bank of China’s (PBOC) announcement on 11 August to devalue the Chinese yuan. The performance of various risk assets suggests considerable discomfort with the policy action. In the United States the week following the announcement was characterised by the largest equity outflows in 15 weeks (US dollar 8.3 billion), the seventh consecutive week of sovereign debt inflows, and the third straight week of money market inflows. Moreover, investors withdrew US dollar 2.5 billion and US dollar 26 billion from emerging market debt funds and equity funds, respectively.

Asset returns in the week following the PBOC’s announcement reveal the acceleration of a trend that began in late May. Equities have significantly underperformed bonds; concerns about global put downward pressure on emerging markets, commodities, and the resource sector. Crowded positions, fuelled by the view that global monetary policy would indefinitely support financial markets, came under intense pressure. Most notably, long US dollar positions were unwound in favour of the euro and Japanese yen following the China devaluation and fears of a more intense global currency war. On the month, absolute returns for the commodity complex were almost 11% lower, global fixed income was about 1% higher, and global equities were down almost 3% (see chart 2 below for detail).

Central banks were supposed to provide ample liquidity and to support financial markets until economic fundamentals flourished and justified subsidized valuations. Yet, there is a palpable uncertainty among investors, perhaps with good reason. At the June Federal Open Market Committee (FOMC) meeting, the Summary of Economic Projections revealed through the dot plots that Committee participants—including the leadership—had become more divided about when to begin the process of policy normalisation. If anything, the minutes for the FOMC meeting on July 28-29 (released in late August) solidified the view that Committee participants were increasingly divided about the timing of the first rate hike. Most participants indicated the economic conditions for policy firming were approaching, yet, the minutes reflected greater concern with downside risks to the growth and inflation outlook. More importantly, the minutes revealed some doubt regarding Chair Yellen’s slack-based framework for determining the inflation outlook.

Board staff projections released this week also introduced some uncertainty about the growth and inflation outlook. Real GDP growth over the medium term was revised down a small amount to roughly 1.65%, in part because of a slightly stronger forecast for the exchange value of the US dollar. The staff also trimmed the projected rates of productivity gains and potential output growth over the medium term. With actual and potential GDP growth both a bit weaker, the projected narrowing of the output gap over the medium term was little revised. However, the staff lowered slightly its estimate of the longer-run natural rate of unemployment. Consistent with the sluggish demand and low productivity theme, US equity earnings growth has deteriorated steadily since the second quarter of 2014. In fact, chart 2 shows that earnings per share growth has turned negative everywhere except Japan.

Over 25 central banks have eased policy this year, global interest rates are at multi-decade lows, two-thirds of the 36 measured PMIs are above the boom-bust 50 level, and energy costs are at multi-year lows. Yet, excess debt, ageing populations, technological advances, and deep-rooted structural imbalances have all conspired to create a deflationary global recovery (chart 1 below provides an overview of those countries where inflation is below the level targeted by the central bank). Seven years after the Great Financial Crises, investors have become well-versed in the objectives of central bankers, which include price stability, full employment, and financial stability. Investors are acutely aware of the tools of the modern central banker and the mechanisms through which they work. But they are quickly realising that broad-based financial repression and competitive currency devaluation is a zero-sum game at best. The question some are asking now is: How does one value financial assets in an environment where central bankers cannot fulfill their mandates?

Chart 1: What if central banks don’t matter?

EN - 1 Countries

Chart 2: Reduced liquidity and earnings weigh on excess returns

EN - 1 Earnings

Source of all data: Bloomberg, as at end August 21, 2015
Timothy Johnson

Head of Global Sovereign Fixed Income at FFTW

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