Markets Run Central Banks

Markets Run Central Banks

Next week the world’s central bankers head to Jackson Hole, Wyoming for the annual Economic Policy Symposium. Investors are fretting over what might be said at the event.

The world’s most important policy makers are in attendance.

Might they flag an end to QE? Interest rate increases?

The market is already wobbling in anticipation…

Take for example ECB President Mario Draghi. His spokesperson is out confirming the lack of anything interesting in his speech in advance, just to make sure the lack of surprises isn’t surprising either.

Why so much the interest in the event?

Central bankers dominate markets more than ever before. There is concern they are overwhelming normal market activity. They’re buying too much of everything.

Here’s a selection of examples…

The Swiss National Bank owns billions of dollars in Apple shares. The Japanese central bank owns over 70% of its domestic stock ETFs. The ECB is mopping up in the corporate debt market and is running out of German government bonds to buy after already maxing out on Portuguese and Irish debt.

The major national banks of the world own a fifth of their governments’ debts. 40% of the Federal Reserve’s balance sheet is invested in government sponsored entity backed mortgage securities.

And so on and so forth…

Swiss National Bank’s US Shareholdings

Swiss nation bank

Source: Bloomberg

With this much influence over markets, a central banker’s slightest mumblings can send stocks into a melt up, or down. They can make or break hedge and pension funds.

But let me tell you what investors haven’t realised yet. Central bankers are fretting over markets to an even greater extent than markets fret about them.

And therein lies the key to forecasting the stock market’s trends…

Just put yourself in their shoes

What would you do in Mario Draghi, Janet Yellen or Haruhiko Kuroda-san’s shoes?

Imagine you were appointed to Chair of the Federal Reserve by Donald Trump this very week on the resignation of Janet Yellen because she is too short to go fly fish at Jackson Hole. Her rubber boots flooded last year. (The annual central bank symposium was first hosted at Jackson Hole to entice avid fly fisherman, extremely tall giant and Federal Reserve Chairman Paul Volcker into coming.)

Anyway, you find yourself as head of the Federal Reserve. What would you do?

Tasked with managing inflation, employment and financial stability, you have to tightrope walk on three planes at once. And those three can contradict.

For the last decade, the only thing keeping the economy afloat has been the vast amount of interference by central bankers such as you. Literally trillions of new dollars, euros, yen, pounds and francs have been used to buy vast swathes of government debt, mortgage securities and corporate bonds.

Without your continued help, the financial world would go through the mother of all withdrawals.

Could governments finance their deficits with new bonds if you try to sell your holdings of the same bonds at the same time? What interest rates would they have to pay?

Could companies and margin borrowers in the stock market refinance their record debts if you increase interest rates?

Who knows whether banks could still write mortgages if you try to sell your trillions of dollars of mortgage backed securities into the market.

Worse still, the stock market flutters the moment you open your mouth. Repeat anything other than the very same words you did at the press conference last month and stocks plummet or surge.

And the world is now fixated on those stock index prices like never before.

Every pay cheque, people plough vast sums of their money, willingly or unwillingly, into pension funds that buy stocks no matter what the valuation, growth prospects, dividend yield or anything else.

It’s a berserk strategy of investing known as “indexing”. Buy no matter what. Here in Australia, our super funds are the worst offenders.

The sudden popularity of index investing leaves you as the responsible manager of all pensions by default because you “control” the stock market.

If you fail to pump stock prices, the concept of retirement in the western world implodes. Thanks to academic research, the pension funds are banking on 7% gains or more per year. Good luck delivering on their promises.

Everyone now has their eyes on your so called “exit strategy”. They burned effigies of Paul Volcker the last time someone had to pull off a substantial exit of overly loose monetary policy.

The only good news is that inflation is nowhere to be seen. The age old accountability mechanism for central bankers is in hibernation. Nobody is sure why.

How do you feel about ending central bank support for the economy and financial system now you’re the one responsible for the decision?

Do you think they will try it?

What would you do?

Would you raise interest rates? Would you reduce QE and sink the stock market, taking down the retirement living standards of everyone around you? Would you stop financing your boss’ bonds in the treasury market?

Only an academic with no awareness of the real world could even handle the responsibility and pressure of central banking.

That’s why Yellen was chosen in the first place. Her blasé attitude to the sub-prime crisis right until the end was extraordinary. Her blasé attitude to the next crisis, which she is setting up, is just as impressive.

How can she say “I don’t believe we will see another crisis in our lifetime” when she is the one financing the next crisis?

Unless, of course, she is right.

Prediction or self-fulfilling prophecy?

Nobody with the potential to become a leading central banker would weather a financial crisis for the sake of imposing sensible monetary policy.

You and I probably wouldn’t do it either. We’d get sucked in like Alan Greenspan.

And so sensible monetary policy is simply not going to happen.

What will happen is very simple…

The moment markets wobble, lending declines, interest rates rise or anything else goes wrong, central bankers will return to QE. Or perhaps some new policy tool.

Watching the projected central bank balance sheet reduction with fear is like worrying your dog will chew off its tail if it ever catches the evasive little fur ball that seems to follow him everywhere.

You’ve fundamentally misunderstood what’s going on.

Markets determine central bank policy, not vice versa.

Until next time,

Nick Hubble,
for The Daily Reckoning Australia