What Happens When Central Banks Stop Propping Up Markets?

Myriad easy money policies have supplied the global markets with a steady supply of newly created cash that has been recycled into stock and bond markets

Dave Sekera, CFA 20 September, 2016 | 10:52AM
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Take the Federal Reserve’s various quantitative easing programs that began almost eight years ago and add the European Central Bank’s recent negative interest rate policy and asset-purchase programmes. Then include the seemingly endless easy monetary programmes from the Bank of Japan, and you can see the markets have long been feeding on a liquidity diet.

Myriad easy money policies have supplied the global markets with a steady supply of newly created cash that has been recycled into stock and bond markets. As this newly created money has been invested, it has helped to send interest rates across the world to historical lows, in many cases generating negative yields, and to push developed market stocks to near all-time valuations – especially in the US.

Will Central Banks Continue to Feed Markets?

The markets’ dependence upon ever easier monetary programmes is starting to be put to the test as investors appear to be concerned that central banks may no longer be as willing to continually force-feed the markets increasingly larger portions of liquidity. The anxiety began after the ECB decided to hold its monetary policy steady earlier this month, as opposed to loosening it further, as expected by the market.

After the ECB’s announcement, the price of many European sovereign bonds quickly fell, which pushed the yields for some bonds back into positive territory for the first time since mid-June. The price on Germany’s 10-year bond fell enough to push its yield into positive territory of 0.02% after trading as low as negative 0.19% in mid-July.

Sovereign bonds had rallied significantly this summer as investors rushed to safety after the UK surprised the world and voted to leave the European Union. Yet even though the yields on many long-dated sovereign bonds have risen back into positive territory, there remains approximately €12 trillion of debt trading at prices so high that if investors hold the bonds to maturity, they will lock in a total loss.

US Bond Yields Rise at Last

Similarly, after hitting their recent lows in early July, long-term U.S. interest rates have continued to rise over the past month. Over the past four weeks, the yield on the 10-year Treasury bond has risen 14 basis points to 1.70%, and the 30-year Treasury bond has increased 17 basis points to 2.45%. This week, investors will be paying attention to the outcome of the Federal Reserve’s Federal Open Market Committee’s meeting September 21, which includes an updated release of the Fed’s economic projections.

Investors will also be paying attention to the Bank of Japan’s monetary policy meeting held on those same day; however, the Bank of Japan is not scheduled to release updated economic projections. Investors may be hoping for some additional policy easing from the Bank of Japan, as there has been much market speculation that Japanese policy makers may increase quantitative easing programs in a bid to stimulate their domestic economy.

Expectations of a Rate Hike Dwindle

At the beginning of the year, the market was expecting three to four interest rate hikes in the United States in 2016; however, this expectation has dwindled to only one. Currently, the futures market is pricing in a 12% probability that the Fed will hike the federal funds rate after the September meeting, but the probability that the Fed will hike rates in December rises to 55%.

The U.S market is currently pricing in a high probability that the current ultra-loose monetary policy will remain in place over the near term. After the December meeting, the market-implied probability of an additional rate hike is only 25% through July 2017.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Dave Sekera, CFA  is a senior securities analyst with Morningstar.