No Happy Ending for Investors in Central Bank Fairy Tale

You know it’s a special moment in the financial markets when analysts ditch the jargon and reach for artistic references.

Ed Yardeni cited “The Wizard of Oz.” International Monetary Fund Managing Director Christine Lagarde went with both “Alice in Wonderland” and Harry Potter. Stephen King -- the HSBC Holdings Plc chief economist, not the author -- trolled the fantasy aisle.

Their message for investors: Even after the MSCI World Index’s lurch to its lowest since February, sentiment risks souring for a while longer. The reason is that just as global growth is weakening again, central bankers who sustained much of the expansion are running out of ammunition.

“Investors around the world are shocked, shocked that the monetary wizards may have run out of magic tricks to revive global economic growth,” said Yardeni, president and chief investment strategist at Yardeni Research Inc. in New York. “Even the wizards are admitting that their powers to do so are limited.”

To King, markets spent most of this year caught up in a fairy tale that policy makers were on top of things.

In the rosy scenario, the Federal Reserve would next year cool U.S. growth with tighter monetary policy and the European Central Bank would revive expansion with quantitative easing. Everyone would win.

‘Something Wrong’

“Like most fairy tales it can’t be true in reality,” King told a conference in Washington last week. “There’s something wrong with it.”

A case in point is the reliance of the ECB on the weaker euro to deliver an economic boost. That’s not likely to work because what matters is its trade-weighted value. On that basis, he calculates sterling and the yen both fell 20 percent when their authorities pursued easier monetary policy in recent years.

The problem for the ECB is that countries are now more resistant to their own exchange rates strengthening. Switzerland and the Czech Republic are capping their currencies against the euro; Sweden is unhappy with gains in the krona. The Bank of Japan would likely push back against any gain in the yen. Australia and New Zealand also have signaled disquiet with strength in their dollars.

To compensate for all that, the euro would have to fall to parity against the greenback.

“That’s way bigger than anything that anyone is currently forecasting,” says King, whose colleagues forecast the euro to fall to $1.19 by the end of 2015 from $1.27 today, which would amount to a 3 percent decline on a trade-weighted basis.

The upshot? Either the ECB’s stimulus efforts fall short or the dollar goes through the roof, preventing the Fed from raising interest rates and hitting dollar-reliant economies in Latin America and China.

Spinning a real-world warning from the film “The Big Lebowski,” Alberto Gallo of Royal Bank of Scotland Group Plc tells investors “you’re entering a world of pain.”

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