We may be seeing the economic regime of markets driven higher by central bank stimulus coming to its natural end.
Over the past few years, I have often wondered what would lead to the end of the era of central bank stimulus. To quote economist Herbert Stein, “If something cannot go on forever, it will stop.” Some economic pains inevitably come when central banks stop quantitative easing (QE) programs, a reality that makes it difficult to stop these programs voluntarily. But if that is the case, is there anything that could cause this clearly unsustainable policy to cease?
Former U.S. Federal Reserve (Fed) Chairman Ben Bernanke, to his credit, began the process of winding down QE before handing over the reins to current Fed Chairman Janet Yellen. However, Mario Draghi at the European Central Bank (ECB) and Haruhiko Kuroda of the Bank of Japan (BOJ), picked up the mantle, and helped push the amount of total global QE in 2015 past the levels of 2014, even after the U.S. Fed stopped its purchases.
In 2014, the Halloween shock and awe stimulus from Kuroda was met with additional weakening of the yen and the strengthening of stocks, as reflected in the Nikkei Index (Figure 1). Fast forward to early 2016 and we see Kuroda once again surprising the markets, but this time the shock and awe stimulus had the opposite effect of strengthening the yen and weakening the Nikkei (Figure 2). Why?
Now central bankers are out of ammunition. Rather than accelerating the already rapid pace of their asset purchases, they are turning to negative interest rates to stimulate growth. Negative rates are very damaging to the banking system, which has already been in pain from years of low rates. The market reacted quickly to this news with a 25% year-to-date selloff in Japanese banks (Figure 3).
Central bank policy has entered a new era where it has turned against itself. Instead of QE stimulating risk assets as we have seen in the past, it is now having the opposite effect. This turn of events has profound implications and signals that a regime change is underway in the markets. In the past, central bank intervention suppressed volatility and pulled forward returns. However, this new regime is likely to bring a period of higher volatility and lower returns.
The ECB targeted negative rates first in 2014 and more aggressively in 2015. At the end of 2015, new rules came into effect imposing debt write-downs on bank bondholders. Portugal imposed losses on bondholders even ahead of that. While these rules were expected, and the negative rates had been in place for some time, it seems that the specter of Japan helped kick off a large sell-off in European banks and equities as well.
In the two regions that are using QE more aggressively (Japan and Europe), the banks and markets have sold off hard. This sell-off signals a change in the playbook. The playbook that had been in place since 2009—the one based on aggressive central bank policy—no longer wins the game. The playbook for this new era is much more complex and requires a much broader toolkit to execute it.
Follow us @OppFunds for more news and commentary.
The Nikkei 225 Stock Average Index is a price-weighted index comprised of Japan’s top 225 blue-chip companies on the Tokyo Stock Exchange.
The Nikkei 500 Bank Index is a subgroup of all the bank-related equities within the index.
Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.