The central-bank put lives on.
Policy makers deny its existence, yet investors still reckon that whenever stocks and other risk assets take a tumble, the authorities will be there with calming words or economic stimulus to ensure the losses are limited.
A put option gives investors the right to sell their asset at a set price so the theory goes that central banks will ultimately provide a floor for falling asset markets to ensure they don’t take economies down with them.
Last week as markets swooned again, it was St. Louis Federal Reserve President James Bullard and Bank of England Chief Economist Andrew Haldane who did the trick. Bullard said the Fed should consider delaying the end of its bond-purchase program to halt a decline in inflation expectations, while Haldane said he’s less likely to vote for a U.K. rate increase than three months ago.
“These comments left markets with the impression that the ‘central-bank put’ is still in place,” Morgan Stanley currency strategists led by London-based Hans Redeker told clients in a report yesterday.
Matt King, global head of credit strategy at Citigroup Inc., and colleagues have put a price on how much liquidity central banks need to provide each quarter to stop markets from sliding.
By estimating that zero stimulus would be consistent with a 10 percent quarterly drop in equities, they calculate it takes around $200 billion from central banks each quarter to keep markets from selling off.
With the Fed and counterparts peeling back their net liquidity injections from almost $1 trillion in 2012 toward that magic marker, King’s team said “a negative reaction in markets was long overdue.”
“We think the markets’ weakness owes more to an almost belated reaction to a temporary lull in central bank stimulus than it does to any reduction in the effect of that stimulus in propping up asset prices,” they said in an Oct. 17 report to clients.
Bank of America Merrill Lynch strategists said in a report today that another 10 percent decline in U.S. stocks might spark speculation of a fourth round of quantitative easing from the Fed. That would mimic how the Fed acted following equity declines of 11 percent in 2010 and 16 percent in 2011.
The good news for investors in the eyes of Citigroup is that although the Fed is still reversing and set to end its bond-buying this month, the European Central Bank and Bank of Japan will more than compensate with more stimulus in coming months.
The reason for the support is the fear that a prolonged sell-off in markets would upend the fragile economic outlook central banks are charged with safeguarding, they said.
“With central banks much more concerned about a return to recession than about asset-price bubbles, they have little choice but to step back in,” said Citigroup.