Nobody knows how the Great Unwinding of central bank stimulus policies will develop. The world has simply never been in this position before. Thus the senior economics and business correspondent of the Financial Times, John Plender, began an article this week:
“In a market where asset prices are comprehensively rigged by central bankers, rational investment becomes impossible. Discuss.”
Exchange rates have been a key target for central bankers:
- The US Federal Reserve tried to boost exports by devaluing the US$
- The Bank of Japan has aimed at devaluing the yen to boost exports and inflation
- The Bank of England has aimed to devalue of the pound
- Now the European Central Bank is trying to devalue the euro
The problem is that these interventions are on such a scale that markets have become unable to fulfill their key role, of price discovery. We simply don’t know the real prices at which currency markets would trade, if central banks were not dominating the financial flows.
Thus the road back from financial stimulus, the Great Unwinding, is likely to be bumpy at best and will probably become quite scary.
The chart above of the US$ Index highlights the position:
- It has fluctuated 25% on several occasions between 72 and 90 since the middle of 2008
- First there was a ‘flight to safety’ in H2 2008, as the Financial Crisis took place
- Then the US Fed pushed the value down again with its first Quantitative Easing (QE)
- When traders tried to buy the US$ again in 2010, new QE programmes kept the $ weak
Thus as with crude oil, the US$ Index has traced out a large triangle. This suggests that the US$ would rise, if the Fed stopped trying to push it down.
Importantly also, the chart shows a strong move upwards is again underway. This is probably also connected with a growing sense that hopes for strong economic growth in Europe and China are simply wishful thinking.
These US$ and crude oil moves are self-reinforcing. Pension funds bought into oil markets as a ‘store of value’, as they saw the US$ being devalued. So if the US$ is rising, they have no need to buy oil and other commodities.
But will the US Fed allow this move to continue? Recent speeches by the new Fed Chairman, Janet Yellen, have been equivocal at best, suggesting she is not clear about the best policy to adopt. There is also the fact that to some extent, events are moving out of central bank control, particularly with the Ukraine situation hotting up.
If we assume for a moment that the US$ continues to rise, then the recent flows of money into high-risk assets will quickly reverse. These have been largely created by the Fed’s decision to supply unlimited amounts of low-cost money:
- Pension funds and hedge funds have simply bought anything that offered a high yield, in a desperate effort to maintain their returns for investors and pensioners
- They have only thought about the need to focus on ‘reward’, and have ignored the fact that high reward usually also means ‘high risk’
But if money flows back into the US$, then ‘risk’ will return with a bang. Who will buy all the assets that are being sold?
This is the great unknown ahead of us. One key area of risk is the future direction of interest rates. Will these remain low, or will investors suddenly realise that the debt they bought so happily may never be repaid? Equally, will investors start to question whether today’s high equity prices can be maintained, if growth remains slow?
We cannot know the answers to these questions. But prudent companies and investors will need to spend time developing their ideas about potential Scenarios. It could be very dangerous indeed to simply assume that the unique circumstances of the past few years will become permanent