Friday, 21 September 2018

The central bank cavalry isn’t coming

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  • James Saft

James Saft to investors: It’s not all about you.

The pain is increasing in global markets, but the likelihood of immediate relief from the Federal Reserve and the European Central Bank isn’t.

A novel idea, that the Federal Reserve won’t send the cavalry every time risk assets fall by a few percent, will in itself be profoundly unsettling to investors used to conflating their own wellbeing with that of the global economy. But with transition to new leadership and no sell-off in critical government bonds, it will take more than a few percent off equities to prompt a U-turn on the Fed’s decision to trim bond purchases.

The ECB is if anything less well positioned to provide balm, though given its track record and the euro zone’s institutional issues this will come as less of a surprise.

Developed market equities fell sharply on Monday, with U.S. stocks adding to losses logged in January, taking the Standard & Poor’s 500 index  more than 6 percent below its recent all-time highs. Emerging markets, which have been hit with a sort of mini-crisis as the Fed tapers bond purchases, also fell amid notable volatility.

Like people after the discovery that the sun does not revolve around the earth, investors face their own Copernican shift: the bitter news that they are an instrument of monetary policy rather than its sole aim.

While this all was likely touched off by the Fed’s decision in December to begin to cut the amount of bonds it buys monthly, there are some very good fundamental reasons for investors to be concerned.

Data out of both China and the U.S. showed a sharp and, in the case of the U.S., unexpected, slowing in the growth of manufacturing.

In China, where the central bank is trying to rein in the growth of credit in the shadow banking market, official data showed manufacturing growth at a six-month low, and the service sector expanding at the slowest rate since 2009.

In the U.S., where until recently optimism about manufacturing was high, new orders reported by factory managers fell by the most in 33 years. That may well have been a blip caused by an exceptionally cold winter, but, twinned as it is with disappointing job growth, it paints a picture of a less robust economy.

And in Europe, where manufacturing data was a tad better, inflation is low and falling, just 0.7 percent annually in January, raising the possibility of deflation.

Remedy for every ill?

While soft job growth, deteriorating manufacturing conditions and a deflationary scare are not to be taken lightly, especially when combined, the real wound, at least in terms of securities prices, may be the fact that the Fed, at Ben Bernanke’s last meeting last week as chairman, elected to reduce further by $10 billion per month its purchases of bonds.

Many investors had hoped that turmoil in emerging markets would prompt, at the least, some calming mention in the accompanying statement of volatility or that the Fed was watching matters.

That did not happen, the bad data did, and the developed markets sell-off ensued.

It is important to understand that investors have been habituated, like users of pain-killers, to relief from the Fed when they show signs of even slight distress. The idea that the Fed can’t and won’t always ensure steadily rising asset prices may prove to be the slap-your-head lesson of 2014.

As for the ECB, which has a meeting this week followed by a policy announcement on Thursday, any decision to address falling inflation may have to wait. ECB President Mario Draghi detailed two triggers for additional policy accommodation: deterioration in the medium-term outlook for inflation or an “unwarranted” back-up in interbank rates. Neither trigger has been fully met, and while the ECB could in future get creative by buying securitized bank loans or some other QE-like maneuver, it is likely to want to do so with a bang and after stronger provocation.

As for newly installed Fed chair Janet Yellen, she faces a tough introductory period. There is no meeting scheduled until mid-March, and even then she would be wise to reverse course on the taper only with weaker economic data as justification. That means we could have yet another weak, but not disastrous, jobs report this Friday and still not be assured of a change in policy.

Markets, therefore, will be left dangling, and investors will not like it.

Like people after the discovery that the sun does not revolve around the earth, investors face their own Copernican shift: the bitter news that they are an instrument of monetary policy rather than its sole aim.

(At the time of publication James Saft 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

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