Buyers beware: Is the central bank credibility crunch point approaching?
Market contrarians continue to close out their short positions on stocks, bonds and risk currencies as buying supports market levels, record low bond yields and emerging market assets.
But can central banks continue to win the confidence game and herd investors into riskier trades, or will the credibility of Draghi, Kuroda, Carney and Yellen ultimately be tested, triggering a wave of negative sentiment that could wipe out this unloved rally?
As one market participant has put it: the central banks are now more risk-loving than ordinary lenders. This is an extraordinary call, given central bank chiefs were forced to mop up the mess of the financial crisis triggered by the leverage created by the banks.
Scott Thiel, deputy chief investment officer of fixed income at Blackrock, acknowledged that it was an interesting thought in light of the European Central Bank’s corporate bond-buying programme which carries the risk of single issuer exposure.
But some are warning that the crunch point is coming. Fasanara Capital’s Francesco Filia said that, on the one hand, QE was useful to avoid a short circuit and create animal spirits. But on the other – because QE affects return expectations on all asset classes, killing savers, making them feel poor, increasing saving propensity over consumption and investment – we are running the risk of becoming disinflationary.
“QE is joined by fiscal policy or helicopter money or it runs the risk of being discontinued altogether,” he told CNBC. Which raises the question, have investors all been directed into a pen for slaughter?
Thomas Moore, investment director of UK larger companies at Standard Life Investments, predicted a snap-back on the valuations of the companies he covers after a post-Brexit rally in the FTSE 100. “Not only is the gap between equity yields and bond yields extreme, sector valuations are also at extreme levels, as is the gap between cyclicals and defensive valuations, which is higher even than 2008-09.”
Central banks have effectively removed the volatility by interfering with the risk-free rate. That has left many, including Blackrock’s Thiel, warning about holding traditional safe-havens, sovereign bonds.
“For developed markets, the risk-free interest rate exposure is something you should look at paring back, so treasuries, bunds, gilts and Japanese government bonds. Given the suppressed level of yields, that is not an attractive asset class for us to own,” said Thiel.
The out-of-kilter world of negative rates enabled German household products maker Henkel to issue two-year bonds at negative rates last week. It has left many investors on the hunt for quality turning to emerging markets where the inflows have been described as extraordinary.
“We are a little bit concerned about those flows reversing or at least slowing down. Our emerging market allocation is about single stock selection rather than a broad exposure to the asset class,” said Thiel.
But natural caution around crowded trades may not necessarily be because investors will immediately call the central banks’ bluff.
“We have to take a deep breath and remember the purchasing power of the central bank community is extraordinary. The Bank of Japan owns around 40 per cent of Japanese government bonds. There is a reality that there is one gigantic price insensitive buyer so to position for change would have a dramatic impact on asset prices, you are fighting effectively the entire central bank community,” said Thiel.
“It’s a topic to think about in the medium term. Why is the yen yield curve not steepening as much as it should? Maybe the market is believing we’re coming to the end of the effectiveness of Japan’s monetary policy. Whether we get something like that in Europe or the States is a question.”
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Others agree it is a risky gamble to bet against the might of central banks which still have ammunition to throw at economies.
“If the question is can the central bank generate inflation, then I think they have unlimited fire power, if they want to generate inflation they can. I think the credibility issue is irrelevant,” Daniel Morris, senior investment strategist at BNP Paribas, told CNBC.
Unfortunately, it leaves investors with symptoms of chronic indigestion and insomnia. But even a GP might tell you to grin and bear it, because it’s the only trade in town.