Investors losing their faith in central banks

Investors and the financial markets are questioning the ability of central banks' stimuli to revitalize global economies, despite promises to do whatever it takes and increasingly unconventional and unprecedented actions.

Since the 2008 financial crisis, central banks around the world have introduced multiple rounds of quantitative easing and other monetary policies. Weighing on the minds of investors and financial markets are recent European Central Bank and Bank of Japan moves to push interest rates further into negative territory; the Federal Reserve's reticence to further tighten the economy; and the threat of a U.K. exit from the European Union in a referendum this June, which sources warned could lead to further QE from the Bank of England.

While there is evidence that policies can deliver — asset prices rise, currencies depreciate, spending recovers and unemployment falls — questions remain about the ability to reinflate economies, and the efficacy of central bank action.

“The sort of impact and the half-life (of reactions) seems to be diminishing,” said David Riley, head of credit strategy at BlueBay Asset Management LLP in London. “It does seem to be a bit of a cycle where central banks are having to pull more and more rabbits from the hat, just to keep the applause going — which is tending to fall away more and more quickly.”

A loss of confidence in QE and monetary policy “is almost exactly what has happened since the beginning of the year,” said Simon Hill, London-based chief investment officer and senior investment consultant at Xerox HR Services, formerly Buck Consultants. “The very sharp shift in markets the last couple of days of December, and into January, was indeed a reflection that markets have lost confidence in the ability of central bankers to manage things successfully as they did (in the past.) QE is only part of that; interest rate policy is another aspect: but the idea that central bankers would be one way or another (able) to sort things out has been undermined — not by anything they have done, but by a loss of confidence.”

The ECB and Bank of Japan were top on sources' minds when discussing the diminishing impact of central bank moves. The ECB announced March 10 further cuts to interest rates, with the rate on the deposit facility descending further into negative territory. A e20 billion increase in the bank's monthly asset purchase program to e80 billion and an extension of the types of assets that the bank will purchase were also announced. Japan announced a move to negative interest rates in January and, like the ECB, did not rule out further cuts and policy action.

“Measures taken recently by the ECB and the BoJ (are) aimed at boosting long-term inflation expectations, in order to safeguard the long-term inflation outlook,” said Bastien Drut, strategy and economic research at Amundi in Paris. “However, market-based long-term inflation expectations have not risen so much in the eurozone and in Japan. So, there has been a growing disconnection between central banks' objectives and what they achieve.”

The impact is being felt in the anticipation, rather than the implementation, of action, said sources. “It's true that we rarely get "shock-and-awe' policy announcements these days, where changes in policy stance lead to a sudden and significant correction in bond yields, stocks and currencies in the immediate aftermath of a policy announcement,” said Richard Barwell, London-based senior economist at BNP Paribas Investment Partners. “But that has much more to do with the fact that investors have become accustomed to unconventional monetary policy and increasingly anticipate the stimulus package in advance.”

“There is an unevenness of success around central bank policies — none have been an unmitigated success, but vary between transmission available and the fatigue which has come in,” said Paul Markham, London-based global equities portfolio manager at Newton Investment Management. Zero interest rates are having “an erosive impact on wealth,” with retiree savings being penalized. Whereas they would historically have lived off of income, dividends and interest from their savings pool, they are having to “dig into their capital to live.” That means wealth is not transferring to the next generation, he said.

Eric Lascelles, Toronto-based chief economist at RBC Asset Management Inc., measures the success of central bank action on three criteria: success in lowering borrowing costs; increased risk appetite and revival of other financial markets; and increased money supply.

“I would say negative interest rates by themselves have proven to be a less effective tool than early stimulus pursuits,” Mr. Lascelles said. However, the “cocktail” of moves by the ECB can be effective. The central bank's move into the corporate bond market, “which has been illiquid and suffering quite wide credit spreads, seems to have revived the ability to deliver stimulus in a world with interest rates close to zero. Don't underestimate the cleverness that underlies the liquidity program by the ECB — it helps to address lingering concerns about banks,” he said. He expects to see further stimulus, of the cocktail variety, from Japan.

When considering the efficacy of QE, Tom Brooke-Smith, London-based senior investment consultant at Willis Towers Watson PLC, considers QE's impact on portfolio rebalancing. “Through purchases or announcements, investors are incentivized to move out on the risk curve. When QE first came in, following the events around Lehman (Brothers in 2008) risk premia were much wider. Government bond yield curves were much steeper, gilt yields were much higher - 4.5% vs. 2.5% today at the long end. Headline programs are becoming less impactful, or central banks need to do more to get some reaction in terms of reduction in risk premia,” he said.

But the move into negative interest rates has spooked investors, said Mr. Barwell. “The recent angst about the ineffectiveness of monetary policy has much more to do with the perceived impact of negative rates than with further QE.”

Investors in the past treated negative rates as a tool to support economies, but “investors became increasingly concerned that cutting rates further into negative territory would prove counterproductive, because nobody would enjoy the benefits of a cheaper currency if every central bank was going subzero at the same time and everybody would pay the cost of a weaker domestic banking sector,” Mr. Barwell said. Should negative interest rates do more harm than good, “central banks are closer to being out of ammunition than previously thought.” He said that was illustrated by Japan's surprise negative rates move, for which “the market surprised the Bank of Japan by treating the good news of monetary stimulus as bad news in disguise.”

“At some point, if you don't have real economic benefits of policies and inflation isn't manifesting itself, growth isn't there, and yet monetary policy keeps on pushing, you do lose credibility and the channel to impact markets,” said Wouter Sturkenboom, London-based senior investment strategist at Russell Investments. “Where monetary policy on its own loses its potency, then (markets) need to think about whether fiscal policy, or a combination of the two, will be implemented. We don't think we've reached that point yet - although it is obvious that Japan is closest, eurozone second and the U.K. and U.S. are pretty far away. In that sense there is always firepower left - but the central bank does run out of its ability to employ that singlehandedly.”

“Markets increasingly understand that monetary policy alone cannot do everything. Now that central banks have done their part of the job, the solution lies in a mix of structural reforms, fiscal policies and banks' restructuring,” added Amundi's Mr. Drut.

But while central banks have ammunition still to fire, a deterioration into deflation would require “plenty of ammunition,” warned Mr. Barwell.