Are Central Banks Really Protecting Us?

Includes: SPY, VGK
by: Kevin Flynn, CFA


The Bank of International Settlements issued some significant warnings in its latest Annual Report.

The Fed and the ECB seem likely to keep their own counsel.

Markets are showing the usual indifference to the economy.

A little bit of defiance, a little bit of desperation is creeping into some of the market discourse. In my experience, it's another marker that says the end is on the horizon - though not one that says it's just around the corner.

Start with central banking. Chatting up reports from the Swiss-based Bank of International Settlements (BIS), usually referred to as the "central banker's central bank," isn't the surest way to liven up a party, but having a fairly broad streak of pointy-headedness, I do like reading them.

An advantage the BIS enjoys is that it is not in the business of needing to protect a home market: If the Fed or the Bank of International Settlements were to say stocks or bonds are pricey, markets would go berserk. When the BIS issues warnings, they get a bunch of emails from fellow economists. No doubt that may lead to a moody lunch or two for some of the staff, but it's not like getting dragged before a bunch of financial illiterates - you know, elected officials - eager to turn you and your work into a primitive mess for the cameras.

That leaves the BIS free to ring the alarm bells, something that individual central banks only do after the fact. One of my favorite comments from the BIS 2007 annual report is the observation that "simply looking into the mirror of central banks' convictions could well prove a dangerous strategy." It presciently added that "the market reaction to good news might have become irrationally exuberant," and "the observed resilience of markets...has increasingly encouraged the view that lower prices constitute a buying opportunity," as well as "should liquidity dry up and correlations among asset prices rise, the concern would be that prices might overshoot on the downside. Such cycles have been seen many times in the past." It should sound familiar enough to recommend your reading at least the conclusion section if you have the time.

The 2014 report (the bank has a June fiscal year) comments acerbically that "financial market have been exuberant over the past year...dancing mainly to the tune of central bank decisions...Obviously, market participants are pricing in hardly any risks." Consider as well this warning: "Overall, it is hard to avoid the sense of a puzzling disconnect between the markets' buoyancy and underlying economic developments globally."

Is the disconnect so puzzling? Though the report observes that "over time, monetary policy loses traction while its side effects proliferate," and the Fed itself has produced recent studies showing little to no boost to growth from the last rounds of quantitative easing, here is one prominent asset manager demanding QE from the ECB, a phenomenon I have observed several times over the last week as the European markets have pulled back a few percent. It's only coincidence, I am sure, that such a program would presumably generate as its main benefit higher prices for his European investments. As for the "puzzling disconnect," well, have a look at this all-too-common view of the Fed backstopping this market.

Not for the first time (or last, no doubt), I don't see the Fed as sharing the concerns of the BIS. The chair of the Federal Reserve is after all a household name around the globe, while most people have never even heard of the BIS. Who do these people think they are, anyway? In reading the latest Fed minutes, the concern over financial market stability is as pervasive as ever and was repeated in Janet Yellen's speech of July 2nd, reinforcing my fear that the Fed believes it can manage market perceptions as needed, though the comments make the Fed look like prisoners of the market rather than the other way around. The BIS repeated one of my oft-written fears, that current and recent policy has left the central banks little room to maneuver. While Yellen's remarks did throw a bone to the need to monitor excess, she handily concluded there was little to none. Upon reading them I heard a voice in my ear saying, "the subprime mortgage crisis appears to be contained."

The BIS is based in Switzerland, and may well have been trying to warn the European Central Bank (ECB) more than the Fed. At the moment, it doesn't look the ECB is any more likely to take the advice either, though the track record of the BIS suggests taking its warnings to heart. I think it rather more likely that the world's principal central banks will go on looking in their own mirrors until it's too late.

There's also a bit of desperation in the investing air, ranging from the apocryphal (and false) story going around that S&P earnings were really between 5% and 6% in the first quarter, to a money manager asserting on CNBC at lunchtime this week that "every economic release, and i mean every one of them, was better than expected last week." I have called out the first story a couple of times in print, and I don't understand the second one at all. The numbers were mixed last week, with the Chicago PMI, both ISM surveys, May construction data, May factory orders and the latest weekly claims number all missing consensus estimates. The purchasing manager surveys were still decent, but they did miss. Beating estimates were June employment, pending sales, the Dallas Fed survey and monthly auto sales. I'd make it about 50-50.

For that matter, why did Tim Seymour, the Fast Money regular on CNBC, assert that the Chinese trade data was better than expected? The year-on-year export figure of 7.2% was far short of consensus calling for 10% (imports missed widely as well). Naturally everyone talks their book, but this kind of misinformation - in both cases, rather defiantly and aggressively asserted - is unusual on television (in contrast to online comment sections, where people can and do assert just about anything.

There has been considerable publicity of the fact that the latest labor turnover survey showed a new high in job openings - but what's not being talked about is that the hire rate is the same as it was a year ago (3.8%). Hires are barely up (3.7%) from a year ago; take away retail trade and the improvement nearly disappears.

When the kind of reaching cited above starts to proliferate, it's a sign we're in the late innings. Yet the main action in the markets this week has been business as usual. Despite all the nonsense thrown about, the main reason for the Monday-Tuesday sell-off was that stocks were short-term overbought and any excuse was sufficient to cool things off. The Wednesday rebound was just another routine Fed minutes rally based on the bank not unveiling any nasty surprises. Thursday's sell-off came to an abrupt halt when the S&P 500 tested the 20-day exponential moving average (EMA). What the bounce really reflected was the notion cited above - the Fed is still backstopping the market, so it's safe to play these trades. Yet while it's hard for me to urge caution when others are doing so - once a market move becomes widely expected, it's nearly doomed - I would note that the S&P is overdue for a trip to the 50-day EMA. I've very little doubt it will be bought.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.