There is a widespread feeling within markets that valuations have gone too far too soon. For example, you’d find it difficult to find someone willing to argue that the equity market today reflects the severity of the impending recession and the erosion of corporate earnings. The thing that has defined the stock market’s triumphant recovery is central bank action. Authorities from the Federal Reserve in the US to the Bank of Japan have poured trillions of Dollars into the financial system and ensured that the ongoing cost of financing new and existing debt remains negligible. There are and will always be concerns that this monetary financing creates distortions in valuations and that’s true, but it’s not a huge issue… for now. The threat that monetary policy faces today that, if realised, would cause havoc to the foreign exchange market, is when central banks go too far.
We used to think interest rates could not go below zero. My dusty economics text books attest to this doctrine claiming their limitation comes when rates are already close to the zero lower bound. Clearly monetary action in Europe and Switzerland defy this theory. There is now a different challenge and it comes when central banks abuse their power.
Central banks find their power in the market’s belief that they are omnipotent. Ideally, the tool kit within a bank remains enigmatic to some degree and the depth of those instruments should be similarly unknown. The perception of unknown strength maintains the authority of the bank. The whole thing breaks down when central banks have to start justifying their actions. This is the reason why the German court’s challenge to the ECB is so potent. In good times the central bank should nod at the direction of future policy and the market steer the underlying instruments to the bank’s target. The concern is that when central banks throw the kitchen sink at a problem time and time again showing the same hand the illusion of their infinite power breaks down. At the same time their ability to stimulate the economy breaks down and the costs of additional stimulus begin to outweigh the benefits.
I was horrified to hear Michael Saunders of the Bank of England last week claim that it is safer to ease too much than too little. Sure it is important not to underplay the bank’s hand to ensure against redundancy and default in the real economy but this is absurd language from an established monetary policy committee member. It appears the external member has forgotten the power and potential damage that the instrument his bank wields can cause.
On Thursday this week the ECB has its latest monetary policy announcement. It is expected to take additional steps to soften the blow of coronavirus on the Eurozone economy. It is expected to expand its Pandemic Emergency Purchase Program – the latest €750bn quantitative easing program in a long line of action. The additional spending will continue to escalate the rift between proponents and opponents to the ECB’s QE program but with the current capacity of the PEPP forecast to run out in October this could be a necessary expansion. It seems the expansion of this mechanism is already priced into markets so expect Thursday’s meeting to have limited impact on the Euro. The risk to current Euro strength lies in the possibility that Lagarde once again downgrades her economic forecasts. Central bankers would be well reminded at this time that their power lies in the market’s perception of their strength and ability to target it, and is not intrinsic to any granted powers. The overvaluation of the equity market has been caused by their action and if the market starts to question their responses their straw house will break apart.
Discussion and Analysis by Charles Porter