Centrale banken houden markten onder de duim

Le Jeudi (Luxembourg), 2 September 2014.

Although it is a panoply of factors that theoretically dictates market behaviour, monetary policy is what actually sets the tone. Monetary policy naturally has a major impact: it influences the entire yield curve as well as the present value of other assets (equities, real estate, etc.) through the interplay of discounted future cash flows. Arbitrage mechanisms also come into play: lower interest rates encourage investors to take more risk.

Today, monetary policy’s influence is not only big; it holds the markets under its sway. This can be attributed to several factors. First, the central banks were willing to act when called on, initially during the Great Recession, and then each time economic growth seemed to falter. Moreover, they were always willing to do more, which explains the waves of quantitative easing in the United States. It was the same story when systemic risk began to rise, as illustrated by Mario Draghi’s famous speech in London in 2012, when he promised to do whatever it takes to save the euro. Second, this obviously welcome attitude created a Buy reflex among investors as soon as a central bank began easing policy. As a result, the markets rallied on the least suggestion of new initiatives, like Mario Draghi’s recent comments in Jackson Hole, or messages that the status quo would be maintained longer than expected for official rates (US, UK). Third, this eventually reduced the weight of short-term earnings prospects: disappointing earnings were no problem since they would rebound as soon as monetary policy had a chance to bear fruit. And if not, additional monetary measures would surely be taken. Fourth, the investment horizon was shortened because of greater uncertainty surrounding longer term forecasts (over one year). The markets focused more on the actual level of official US rates than on the level they might reach at end 2015. More than in the past, investors were adopting momentum investment strategies to play this trend.

So far, this dominant influence has supported the markets, but in the future, it is likely to be less one-sided. This certainly applies to the US, where two adjustments need to be made. The Federal Reserve’s message still does not fully reflect the improvements in the US economic situation, and market expectations are not as aggressive as the central bank’s outlook. As to the Europeans, Mario Draghi’s comments during the Jackson Hole conference were seen as a commitment to proceed with an ambitious quantitative easing programme in the near future. The spectacular rise in the equity and bond markets creates room for disappointment if this interpretation proves to be overly optimistic. We will know more after the ECB’s press conference on 4 September.