Why central banks and their policies are contributors to volatility in the markets

Morgan McKinley 08.03.2016

Jonathan Sheahan is a Qualified Financial Advisor and a Registered Stockbroker. He is also a fully qualified Certified Tax Advisor (CTA). He has almost 10 years of experience with different financial institutions in Ireland having worked in Investment Management, Pensions, Tax and Management Consulting.

Jonathan has a keen interest in global macro-economics, investment markets and domestic finances in Ireland and we are delighted to share his views with the Morgan McKinley community.

"We are now less 2 months into 2016 and global investment markets continue to show signs of significant volatility. These levels of uncertainty are generally being blamed on the 2 easy scapegoats: China (slowing economy) and Oil (excess supply & reduced demand).
 
While the Chinese slowdown and falling oil prices are valid factors, in my opinion the main reason for the mass unpredictability is the market’s complete mistrust of Central Bank policymakers.
 
What is unique about the current market is that the values of global Equity, Bond and Currency Markets are being dictated by national or regional Central Bank comments and decisions as opposed to the more traditional and fundamental investment metrics
 
The market is well aware that Central Bank policymakers are responsible for 3 of the most important market-moving catalysts in today’s environment
 
1) Interest Rate setting, 2) Quantitative Easing (QE) programmes and 3) Outlook Guidance & Growth Forecasts. Institutional Fund Managers (aka the people who move the market) don’t like the nature of these catalysts due to their unpredictability and the difficulty in deciphering the implications: hence the selling forces and subsequent falling prices
 
Generally speaking, we associate intra-day market volatility with individual securities such as direct shares & specific commodities. However, what is unique about the current market environment is that we are seeing large cap indexes (such as the US S&P 500, the UK FTSE 100 and the German DAX 30) show significant levels of intra-day highs & lows.
 
National markets are showing knee-jerk reactions to every single hint of an insight from Central Bank policymakers which is very disruptive to investors. The market is more interested in reading the body language of Yellen, Carney & and Draghi than it is in actually looking at the investment case of asset classes, sectors and individual companies
 
Some of the examples of Central Bank market-moving decisions we have seen over the last 12 – 18 months are as follows:

US Federal Reserve:

After Janet Yellen had taken over from Ben Bernanke as Chairman of the Fed, the market was obsessed with scrutinising every single word she said at the various press conferences. After record low interest rates since the Credit Crunch, up until the end of 2015 the Fed had kept the Equity, Bond & Foreign Exchange market guessing on their rate policies. Finally, after raising rates once they then indicated 4 rate rises throughout 2016 in order to provide some stability to the market. However, one month into 2016 and it looked like these 4 rate rises may not actually be the case. One of the members of the Federal Reserve, Bill Dudley, single-handedly moved the USD / Euro rate in one day by c. 2% by making comments that indicated that the Fed would be more dovish that what the market anticipated

People’s Bank of China:

The PBOC have rocked global equity markets twice in recent months: In August 2015 and in January 2016 the Chinese weakened the Yuan by ever so slightly unpegging it versus the Dollar and letting it fall. These completely unprecedented moves completely took the markets by surprise and had massively negative implications for markets worldwide. The market now has widespread unease around the PBOC and this nervousness has been priced into equity markets

Bank of Japan:

The BoJ and Shinzo Abe have been throwing the kitchen sink to stimulate the economy through their own Quantitative Easing programmes. In late January of this year, the Bank of Japan moved to -0.10% interest rates, which gave a short-term boost to Equity Markets, but then dissipated. The Bank of Japan have explicitly stated that they will ‘invent new tools’ to stick to their 2% inflation target. When a Central Bank has already carried out all of the conventional monetary policy measures – and that doesn’t work - the only option open to them is unconventional policy. Watch this space

Europe:

The ECB has already announced an extension to the 19-month Quantitative Easing programme that was announced in February of 2015. If current low inflation numbers in the Eurozone persist, then the ugly deflationary threat in Europe will re-emerge & QE could be extended again. Again, as with all of the other Central Banks, a lot depends on Mario Draghi’s outlook and guidance with more unconventional measures potentially open to him. This creates uncertainty in markets, hence the volatility, hence the selling

UK:

The Bank of England are probably the most stable of all of the above Central Banks, but even at that there are concerns about their future interest rate policies. Mark Carney recently reduced the Bank of England forecasts for inflation to 0.80% for 2016. This will impact Sterling in a big way and as we know for Irish businesses and consumers the Sterling price is extremely important. Some commentators are now saying that an interest rate cut could be just as likely as an interest rate increase. Again – the market is very much in the dark

From the perspective of all 5 Central Banks above, it is clear to see that they have now grown absolutely paranoid about market reactions and that in turn has meant that their credibility is being questioned. Central Bankers are now less interested in sticking to the specific mandates that they were given and are instead more interested in currency wars and stimulating stockmarkets.

Irish Investors need to realise that we are now in the new normal and we need to adapt to this new environment, as I don’t believe it’s going away any time soon.
 
Investors need to continue to focus on building well-diversified investment portfolios with a generous allocation to active fund managers who have a proven track record of managing funds in volatile times. Investors need to also re-think their currency exposures as the direction of the Euro versus Sterling and Dollar is now showing new levels of uncertainty"

Jonathan Sheahan
Managing Director of Compass Private Wealth & Compass Pensions

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