Central banks now lord it over the world’s economy. That has led to a lot of distortions and could end up harming the very system they seek to help.
One sign that all is not right in the field of investing is the increasing volatility. Volatility is not a good thing for investors seeking to limit their risk and markets recently have been as spiked as Jonestown Kool-Aid. The results could be nearly as disastrous.
As the chart shows, currency, oil and interest rates have been up, down and all around. Bonds, too, have been volatile, and price shifts have been taking place with increasing frequency.
It makes me uncomfortable when I see government bonds flash crashing along with currencies of developed markets with enormous debt levels. The Swiss National Bank in January unpegged its currency from the euro, which Switzerland feared would drag down its franc.
And if Japan keeps burning yen, pumping money into the nation’s economy to goose its dragging performance and thus pulling down the currency’s value, trading rival China is likely to unpeg its currency, too. China’s yuan is informally linked to the U.S. dollar, which over the past year has strengthened.
When Beijing uncouples the yuan, it isn’t going to be fun. Look for big disruptions in foreign exchanges and international trade, which affects economic growth and your investments.
Why is this turmoil happening? Because central bankers have become the Masters of the Universe.
As Zerohedge notes, valuations in recent years have synched up to central banks’ quantitative easing or QE – buying bonds to keep interest rates low and stimulate their torpid economies.
The financial website points out: “In meetings with investors, we have been struck by how little time anyone spends discussing fundamentals these days, and how much revolves around central banks. Record-high proportions of investors think fixed income is expensive and think equities are expensive. A growing number of property market participants seem to think real estate is expensive. And yet almost all have had to remain long, as each of these markets has rallied.”
Putting central bankers in charge of the world’s financial systems might have seemed like a good idea back in 2008, when the world needed to be saved and there were few options for saving it. But in the seventh year of ruling the world, the most significant result is that markets have become distorted. The new normal is abnormal.
Zerohedge further notes that “it is expectations of central bank liquidity, not economic or corporate fundamentals, which have become the main driver of everything” from euros to dollars to credit spreads, the difference in yield between Treasuries and other bonds.
One problem with the new order is that it’s unlikely that central bankers can make a smooth transition back to the good, old-fashioned markets that react to financial performance and economic reality, rather than today’s Fed-induced fantasyland.
The Federal Reserve Board was able to end its quantitative easing program without the world coming to an end, but what happens when the Fed raises interest rates, as it eventually must? The stock market could go into cardiac arrest – and, having used all of its tools in an attempt to revive the economy, the toolbox is empty. Even Fed Chair Janet Yellen is no longer talking about “macroprudential supervision,” as a Fed tool. (This refers to the Fed regulating the financial system to minimize risk.) So what’s left?
But someone will have to do something, Zerohedge says, as, “Central bank distortions have forced investors into positions they would not have held otherwise, and forced them to be the ‘same way round’ to a much greater extent than previously.”
When investors are all rushing into the same markets at the same time, prices increase. When they all rush for the exits at the same time, prices decrease. In the bond market, the result is an illiquid market.
Because of this herding of investors, more central banks seek to add liquidity to markets, which ironically become more illiquid. Herding “creates markets which trend strongly, but are then prone to sudden corrections. It also leaves investors more focused on central banks than ever before – and is liable to make it impossible for the central banks to make a smooth exit.”
Add today’s regulatory environment and high-frequency trading into the mix and there’s plenty to worry about. Even the Masters of the Universe may not be able to save us.
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Brenda P. Wenning is president of Wenning Investments LLC in Newton, Mass.
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