Global Central Banks: Below Target

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Includes: BSV, CSJ, SHY
by: Ben Emons

Summary

The ECB and Bank of Japan may come to the "rescue" of global markets once again. Only the market rally may prove brief.

QE has the feature of diminishing marginal returns because too many central banks deploy a QE policy.

Short speculators continue to dominate which makes QE ineffective. Defensive portfolio strategies remain favored.

Two major global central banks may come to the markets' "rescue" once again. These are the European Central Bank (ECB) and the Bank of Japan (BoJ). Both run an identical strategy and objective: continue to ease policy until 2 percent inflation is reached. The central banks' past actions meant a temporary relief for markets however. For example, when the BoJ announced an expansion of its Quantitative Easing Program (QE) in October 2014, global equities rallied 5 to 10 percent for one month before fizzling out. When the ECB announced its QE program in January 2015, global stocks marginally rallied by 6 percent and tapered off. It has been argued QE has a feature of "diminishing marginal returns." The more central banks are doing QE, the less effective it becomes.

QE's diminishing effect is what the ECB and BoJ have found out rather quickly. Just shortly after the launch of QE, extreme volatility appeared in government bonds. The selloff in Japanese Government Bonds in April 2013 and German Bunds in April 2015 reminded markets QE has limits. The volatility persuaded FOMC members such as former Dallas Fed President Richard Fisher and former Philadelphia Fed President Charles Plosser to campaign for an end to the Fed's QE3 program. And as the "taper tantrum" unfolded, it became clear infinite QE is something that meets resistance from momentum in asset prices. The more QE is used, the slower the price appreciation of assets. This is a more complex process when multiple central banks use QE to target their domestic economy. When a central bank targets inflation with QE, it will be subjected to global market changes to achieve the objective. When momentum in markets changes, the central bank can easily undershoot the target, creating the perception QE is "ineffective."

Ineffectiveness can be caused by central bank action because it changes the behavior of speculators in different markets. In the case of Europe and Japan, central banks' effect on the currency helped strengthen the dollar. This led to speculators building substantial long positions in the dollar, resulting in a "super strong dollar" that has contributed over 40 percent to the decline in the oil price since 2014. The dollar effect led speculative net short positions in oil futures to reach a record high. This in turn depressed energy prices, and that was passed through to developed market CPI indices. The statistical rules of thumb of exchange rate effect on inflation changed. Nowadays for every 10 percent rise in the real effective dollar exchange rate and for every 20 percent in the (real) price of oil, the CPI index declines by 0.3 to 0.6 percent. Prior to the crisis, such relationship between CPI, dollar and oil was negligible.

Despite sizeable QE programs, inflation is undershooting the ECB and BoJ's target consistently. A key asymmetry in play is that of QE geared towards a domestic economic agenda while at the same time addressing speculators with different agendas. To the ECB and BoJ, the success of QE hinges on the projection of energy prices. That projection is controlled by speculators. The Fed can validate further hikes if energy price declines prove "transitory." But the speculators have the upper hand in transitory effects. That is not only in oil, but also equity, currency and bond price (transitory) effects.

The ECB and BoJ may expand their QE programs sometime in the next weeks to months. Although this may please part of the speculators, namely those who are long government bonds, the short speculators in currencies, commodities and equities may be enticed by the notion that QE suffers from diminishing marginal effects. In a market place dominated by "technicals" like ETFs, risk parity, momentum strategies and liquidations of high quality stocks and credits, global central banks will continue to undershoot their targets as long as the short speculators dominate. Until the short speculators are flushed out, portfolio strategies should be geared defensively by combining high quality short maturity credits, cash equivalents and moderate duration.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.