- Fed tightening curtails years of support for investors
- Divergence with ECB, BOJ raises risk of greater volatility
Central bankers risk turning more foe than friend to investors in 2016.
After propping up financial markets with zero interest rates and debt purchases for seven years, top monetary-policy makers are becoming a less calming presence as the new year approaches.
The U.S. Federal Reserve has started raising its benchmark rate, and the Bank of England may be next. That not only reduces liquidity, it also threatens to fray the nerves of investors fearing a policy mistake. The European Central Bank and Bank of Japan have delivered less stimulus than markets had hoped for and may again disappoint.
The first international divergence in monetary policies since the early 1990s is adding to the uncertainty, and doubts are mounting over just how powerful unconventional measures such as bond-buying really are anyway.
“Gravity could start to act on asset prices as the policy distortions fade or are curtailed,” said Stephen Jen, founder of London-based hedge fund SLJ Macro Partners LLP.
For an early taste of next year, look back to Dec. 3. The ECB’s ramp-up of quantitative easing fell short of the expectations of investors who’d been listening to dovish statements from President Mario Draghi. The euro climbed the most since 2009 against the dollar and the German 10-year bund yield rose the most in four years.
Or look at last week, when BOJ Governor Haruhiko Kuroda confused markets by announcing a new stock-buying plan without warning. Equities surged -- then slumped again when it became clear the program would only offset sales of separate BOJ holdings.
The worry is that Draghi and Kuroda are less able or willing to provide as much easy money as previously anticipated. They may also have lost some of the communication skills which have served to soothe investors.
It doesn’t have to be so, as Fed Chair Janet Yellen showed last week. While her policy makers raised rates for the first time in nine years, the shift was well telegraphed and she promised future action would be “gradual.” Markets absorbed the tightening without hiccup, with the Standard & Poor’s 500 Index barely changed on the week.
Investors may nevertheless find it harder to digest future rate hikes. Bond traders, for example, are now pricing in around two Fed increases next year, while the so-called dot plot of projections from officials points to four.
“In 2015, the Fed’s dots moved to the market’s expectation,” said Jen, a former International Monetary Fund official. “For 2016, the order may switch around.”
Another risk is that the Fed goes too far and is then forced to shift into reverse -- just as the ECB and every other major central bank which raised rates since 2008 ultimately had to.
Even if the Fed successfully avoids a policy error, its tightening has brought to an end almost a decade of uniform strategy by the world’s major central bankers. That too will be tricky for investors to accept, according to Alberto Gallo, head of global macro credit research at Royal Bank of Scotland Group Plc.
“When central banks are hiking and policy is diverging, volatility and risks both rise,” he said.
At the same time, Gallo sees skepticism about whether quantitative easing even serves to boost inflation and economic growth in debt-laden nations by enough to justify side-effects such as asset bubbles and wealth inequality.
“Investors are growing increasingly wary of central bankers’ credibility and worried about the effectiveness of further stimulus,” said Gallo, who expects central banks will struggle to tighten.
Amid questions about the effectiveness of their current tools, Erik Nielsen of UniCredit Group AG said many policy makers may roil markets next year by trying to weaken their exchange rates as a route to stronger expansions.
“I see a very large number of central banks actively and aggressively fighting FX appreciation, and a few quite explicitly wanting a weaker currency,” said Nielsen. “Central banks have become a key source of volatility.”
Policy makers aren’t completely out of firepower. JPMorgan Chase & Co. estimates the average interest rate for developed economies will remain below 1 percent a year from now, while those who need it could push rates deeper below zero. Bank of America Corp. calculates the combined assets of the four top central banks will reach $13.5 trillion by the end of 2017, up from $11 trillion today, as the BOJ and ECB buy more.
“In a world that has been awash with central-bank liquidity for most of the past decade, the central question for the year ahead is how the global economy and financial markets will react as the tap on that liquidity begins to tighten,” said David Folkerts-Landau, chief economist at Deutsche Bank AG. “While the pivot away from this great monetary experiment is unprecedented and will not be without risks, we expect the world economy and financial markets to weather this turn in policy reasonably well.”