Same as it ever was: Central banks the only game in town.
A terrible amount of energy is expended on financial market analysis. Discounted cashflows, net present value, free cash flows to firms, purchasing power parity and creditworthiness scores—the works.
But all this analysis pales into insignificance compared to the impact of the next moves in central bank policy.
Interest rates drive markets. The major historical turns in financial markets have all seen central banks play a significant part.
The coordinated action to lower interest rates in 1927 by four major central banks led to 1929’s Wall Street Crash.
The US’s move to raise rates in 2005 provoked the subprime disaster in 2007.
And the revolutionary decision to “print money’ after the global financial crisis has seen global asset prices reach record highs over the last few years.
According to historian Niall Ferguson, in The Ascent of Money: A Financial History of the World, “The cost of credit, the interest rate [on a benchmark bond], ultimately determines the value of stocks, homes, all asset classes.”
Back in focus
The upcoming week will again prove that central banks are the only game in town.
In my opinion, we will soon see two of the three major central banks – the US Federal Reserve, European Central Bank (ECB) and Bank of Japan – actively tighten policy. How will this profound change in central bank action impact financial markets?
Outwardly, the year so far has been driven by geopolitical news: Trade wars, the US-North Korea summit, and tensions in the Middle East.
But the two big moves we’ve seen so far in 2018 – the Dow’s big plunge in February and the euro’s selldown in April – have both been driven by perceived shifts in central bank policy.
New chair in town
In the US, sharemarkets plunged in February as investors came to terms with the policies of the new Federal Reserve chairman Jerome Powell.
A better reading from the US labour markets, along with the uncertainty of a new Fed chairman who indicated later that month that he has become more optimistic on the US economy, saw US shares fall 12 per cent in just over two weeks.
At the Fed chairman’s semi-annual testimony to US Congress, on 25 February, Powell said, "we’ve seen incoming data that suggests a strengthening in the economy and continuing strength in the labour market. We've seen some data that in my case will add some confidence to my view that inflation is moving up."
The statement sent US bond yields sharply higher and US sharemarkets have been unable to reclaim their February highs ever since.
When you say nothing at all
In April, it was the European Central Bank that contributed to the other major market move for the year – the euro’s big fall.
After the 25 April policy meeting, in his post-meeting press conference, ECB president Mario Draghi pivoted from his previous stance that data was “confirming our confidence” in higher inflation. Instead, the data only “supports our confidence”.
The shift was seemingly insignificant, but the impact was massive. The EURUSD fell from 1.2500 to 1.1500, while German’s DAX stock index climbed close to 1000 points.
Fed, ECB this week
Former Swiss central banker and now director of Investment firm BlackRock, Phillip Hildebrand, has said that the impact of central bank policy is complex because of the way it flows through the economy. Interest rates impact the cost of capital, the availability of loans, valuation models, consumer sentiment and commodity prices.
In the short-term, politics, tariffs, trade and terrorism – even major summits in Singapore – will shake up markets, but the focus will always return to central policy.
As always, the impact of this week’s meeting of the Fed and ECB just can’t be overstated. Everything else is just noise.