If free and open markets are the Wild West, inhabited by roving bands of asset managers, hedge funds, investment bankers and random traders, then the sheriffs are the central bankers. A change of sheriff makes a real difference to trading conditions. The focus of London traders and analysts has already shifted to a new sheriff with the arrival of Mark Carney at the Bank of England next week, and much anticipation of his new tool of ‘forward guidance’, which he is expected to unveil in August.
Central bankers, far more than politicians, have long held sway over financial markets. That influence is at its greatest at times of economic tumult. We have been sharply reminded of this during the period after the great panic of 2008 and the subsequent great recession. Never have the actions of central bankers been so closely watched or so important to market trends. The co-ordinated interest-rate cuts of early 2009, quantitative easing in the United States and the UK, the recent doubling of QE in Japan and the unveiling of ‘outright monetary transactions’ by the European Central Bank last year, have all driven market trends. In times of turmoil, central banks are the first line of defence.
But like King Canute, central bankers cannot hold back the tides of market sentiment. It was in 1996 that the former US Federal Reserve chairman Alan Greenspan gave a speech mentioning the dangers of ‘irrational exuberance’ in asset prices. Markets took no notice and equity prices soared on the back of a technology bubble that was not pricked until 2000.
Nevertheless, what’s clear is that the great recession and subsequent eurozone crisis have conferred almost magical powers on central bankers as far as analysts are concerned. A quick perusal of recent brokers’ notes in my in-box includes: ‘So Farewell then Sir Mervyn’; ‘Forward guidance is coming but further BoE gilt purchases less likely’; and ‘Could both the BoE and ECB move to explicit forward guidance in August?’ There’s no secret about what the analysts are thinking.
As Governor of the Bank of England, King always has looked to the economic and financial literature for clues about how to behave. His initial embrace of ‘moral hazard’ at the beginning of the financial crisis soon gave way to more practical solutions in the wake of the Lehman collapse. He was at the forefront of those urging radical recapitalisation and surgery on the banks. As the economy sank in 2009, he rapidly reduced interest rates and embraced quantitative easing.
He had no qualms about printing money at a time when fiscal policy has been relatively tight, the economy has been operating well below capacity, and growth in the money supply has been lamentable. Up until his last Monetary Policy Committee meeting this month, King was advocating increasing QE beyond the current £375 billion, despite signs of an emergent recovery.
In the US, it is without doubt monetary policy that drives market sentiment. Each time the Fed chair, Ben Bernanke, hints that super-loose monetary policy may have to be tapered, the S&P 500 dips sharply. Shares in the German insurer Allianz, owner of the Pimco bond fund run by Bill Gross, have fallen sharply since Bernanke’s warning. Pimco’s flagship fund has dropped by 1.9 per cent. It is also the belief that the bulk of American QE may be over that has been a driving force behind the collapse of gold prices, from a peak of just shy of $2,000 an ounce to just above $1,300 in recent weeks.
In the UK fund managers say it is the Bank of England’s QE together with easy-money policy in the US, Japan and Europe (not easy enough, perhaps) that has led to higher allocations of equity investment. Defensive equities have offered better yields than fixed interest, together with the prospect of capital gain. This has helped FTSE100 prices.
What the Carney era may offer is a little bit more predictability on monetary policy. Under King the main guidance came from the Bank’s quarterly Inflation Report press conferences, MPC minutes, and speeches by committee members. Under the Bank’s new remit, set by the Chancellor in the March budget, it’s likely that Carney, like Bernanke, will seek to link interest rates and monetary policy directly to growth and jobs targets
There will be subtle changes but no one, as economists at HSBC have noted, is expecting ‘shock and awe’. The big question for Carney is which indicators to use as targets. The runners are unemployment (as in the US), real GDP, or the measure preferred by many economists: nominal GDP. If that were to be the agreed measure, a current compendium of headline inflation and growth figures might suggest that we were in boom conditions. That would imply taking the famed ‘punch bowl’ away.
In Canadian conditions, Mark Carney was among the first central bankers to cut interest rates to the bone as the subprime crisis hit. As Matthew Lynn wrote here recently, the long period of low interest rates may have produced a Canadian housing and construction bubble, giving rise to fears of a ‘hard landing’ as monetary conditions have been tightened.
When George Osborne recruited Carney, it was assumed that the reason for doing so was to freshen up the Bank but also put some fire under monetary policy. But with the economy starting to recovery and a nascent housing boom on the back of ‘Funding for Lending’ and ‘Help to Buy’ schemes, Carney may feel his tasks are to guide the market towards an end to QE and a normalisation of the official bank rate, which has been held at 0.5 per cent for four years.
In much the same way as actions by central banks have fuelled first a commodity and then an equity market rally, so any signals that monetary stimulus is about to be removed could have the opposite impact. Even the most subtle interest-rate signals can assume enormous significance for investor allocations. Trading technology, derivatives and hedge-fund ‘black boxes’ have speeded the process of adjustment. A gilts market bloodbath could follow should UK policy change direction.
It would be the supreme irony if the handpicked overseas central banker brought to restore growth to the British economy were to put a crimp in monetary expansion. If that does take place, then a sharp swing in investor sentiment will almost certainly be the result.