September 4, 2015
The people prayed to their gods and their prayers were answered, even though most of them were evil sinners.
An alternative description of developments in the financial markets over the last week is that as prices plunged, all eyes turned to the central banks and, as expected, these latter-day saviors delivered the goods. First, the Chinese central bank renewed its efforts to stem the slide on China’s stock market and wider economy. Then, yesterday, Mario Draghi took the stage again.
In advance of the European Central Bank policy meeting yesterday, there was no expectation that it would announce an expansion of its QE (quantitative easing) program. There was, however, an expectation of words or actions that presaged such a move in the not-too-distant future — and it was not disappointed.
ECB President Draghi, in his post-meeting press conference, noted that the Bank’s inflation forecast had been lowered (even further). In the age of QE, too-low inflation is seen as justifying more QE, in the belief that it will push inflation upward. Better yet, Draghi also said that the ECB was adjusting the rules of the QE game, so that it could buy as much as 33% of the total issuance of any government bond — up from 25% hitherto. This was a clear signal that more QE is in the pipeline, and immediately triggered a sharp fall in the euro and further sharp rises in both equity and bond prices.
Across the water, the Fed is not expected to restart QE, which it terminated last November. Rather, the big question is whether and when it will go ahead with its declared intention to start raising interest rates. The mere expectation of such a move is one of the factors blamed, rightly or wrongly, for the recent weakness in equity markets. If the Fed were to backtrack, the financial world would be delighted, but if it decides at its upcoming meeting on September 16-17 to raise, the markets’ response will likely be very negative.
Orthodox vs alternative
The foregoing is the standard framework of discussion of the markets in the mainstream financial media and in much of the market analysis produced by banks, investment houses, etc. But because that is the accepted orthodoxy doesn’t make it the right way of looking at the markets.
An alternative point of departure for analyzing the financial markets, as has been noted here often, is to reject the premise that the central banks and/or the governments behind them can determine the direction of the markets. An objective review of the historical record is that they definitely can do so — in the short term and, to a decreasing extent, in the medium-term. But they definitely cannot do so in the long-term; if they could, there would never be crashes, crises, recessions and other events which the central banks and governments seek to prevent.
In terms of the current state of play in global markets, we are witnessing the longest-ever, largest-ever and most widespread effort by central banks to impose their wills on markets and influence economic activity. No-one believed, back in 2008-09 when this mega-intervention began, that it would or even could carry on as long as it has — yet it has. The result has been that all financial markets have gone to unprecedented extremes — record high levels in share indices, record low levels for bond yields and so on — and belief in the ability of central banks has also gone to peak levels.
Nevertheless, despite the provision of many trillions of dollars of liquidity, market after market has proved unable to maintain their positive trends. Many commodity prices peaked in 2011 or 2012 — along with the rate of expansion of the Chinese economy, it now turns out, and these two are indeed intertwined. Oil peaked back in 2008, but had lesser peaks in 2011 and last year — before crashing.
Equity markets have also succumbed — emerging markets began falling last year, although China embarked on an artificial boom that has ended in a spectacular crash which is still ongoing. Developed markets are only now turning down — and, as noted, there is a widespread expectation, which has the intensity of a religious belief, that the central banks can and will prevent this.
Doomed to fail
But suppose they can’t? All the historical evidence proves that in the long run, governments cannot dictate market direction — and that the greater their efforts to distort market activity, the more counter-productive these efforts prove to be. China has, in the last three months, provided a text-book example of the validity of this rule.
That means that QE is doomed to fail, and has already failed in many countries. Successive ‘rounds’ of QE have generated reduced returns, which is why the Fed has ended its QE and is loth to renew it. Sweden is an example of a country that keeps doing more QE, but even government bond yields no longer respond to this drug.
Draghi’s move is also futile — the more bonds the ECB buys, the more distorted, volatile and vulnerable European bond markets become.
Because the bond market is the most important within the financial system, it should be watched most carefully. Specifically, if yields on government bonds rise further, they will be confirming that a turning-point in the financial and economic cycle has occurred.