Investors are feeling a rather unfamiliar sentiment towards central banks: betrayed.
Not only have the Indian, Danish and now Canadian central banks surprised with interest rate cuts, the Swiss National Bank confounded expectations last week by abandoning its vow to cap the value of the franc against the euro just days after calling the peg a “cornerstone” of Swiss monetary policy.
It isn’t so much that these moves cost people money, because obviously they made different people money as well. Rather it has all eroded the related beliefs that central banks are a) mostly in control of events and b) therefore worthy of being trusted in their promises.
Virtually no economist expected the Bank of Canada to cut rates, as it did to 0.75% from 1%, because though its economy has been hit hard by the tumble in energy prices, housing prices are in bubble territory and debt is a worry.
“It signals a spectacular loss of nerve that central bankers should always try to eschew, above all when you have a country like Canada with the worst household debt levels in the developed world and an overheated housing market,” strategist Marc Ostwald of London-based ADM Investor Services wrote in a note to clients.
“This is symptomatic of the whole mirage of stability that developed world central banks have sought to foster in the post-crisis era starting to unravel in a rather disorderly fashion … The ECB’s task tomorrow looks ever more unenviable!”
Two pieces of advice immediately come to mind for investors feeling newly wary about their central banking friends:
Get over it.
Get used to it.
Get over it
Investors over the past quarter century have grown used to feeling that central bankers were somehow ‘on their side,’ and for good reason. The US under Greenspan and Bernanke ran asymmetrical monetary policy, cutting rates to ease market disorder when things go well but quailing at raising them to stop either the economy or risk taking from going too far.
Between 1990 and 2012 more than 80% of excess returns on US stocks happened in the 24 hours before Fed interest rate announcements, as clear an illustration of the candy-for-the-baby relationship as you could ask.
It wasn’t so much that central banks ‘liked’ investors but rather, when faced with an economic control panel with few levers, they found them useful. Much of the point of quantitative easing, which the ECB should launch on Thursday, was to drive up the prices of risky assets so as to goose spending, investment and growth.
The thing is, though it is well and good to make money by being someone’s tool, it is important to remember the nature of the relationship and its limits.
Get used to it
The idea that central banks will continue to try to use markets and investors as a way to stimulate growth is far from dead. The ECB is turning to QE, the Bank of Japan continues with its massive program and the Fed is arguably still leaving rates at zero despite improving US fundamentals for just this reason.
What is worrisome is the idea that central banks are increasingly feeling forced to surprise markets with abrupt changes in direction. Remember, and you know that central bankers do, that we got through the crisis in large part because central banks had enormous stores of credibility. Every event like the SNB move whittles that down, leaving less to draw upon the next time. Remember that the SNB wasn’t forced to take its step: it can after all print all the francs it likes. It took it because it recognized that the risks, from the ECB, from Greece and from Russia, made the policy not worth the potential costs.
The counter argument to this is that there is a big vs little divide, with the Swiss, Canadians and the like on one side and the ECB, Fed and BOJ on the other. One side is far more vulnerable to changes in the real situation, like the oil bust, while the other can, if you like, ‘make its own reality.’ There is something to this, though obviously the ECB, big as its economies are, is somewhat hamstrung by the lousy institutional arrangements under which it labors.
But note that the Bank of Japan left monetary policy unchanged at its meeting ending Wednesday while saying two contradictory things: that it can hit its 2% inflation target in the next 15 months or so, and that the outlook for core inflation in the same period is falling, not rising.
At some point investors may lose faith or the big central banks, like the Swiss did, may throw in the towel on risk-friendly policy.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
