POINT BLANK. Markets paying for the sins of central banks

When the US Federal Reserve began its quantitative easing during the global financial crisis in 2008, there were many who warned the Fed against embarking on this path, including the Reserve Bank of India’s ex-Governor, Raghuram Rajan.

More than a decade later, such voices have become quite rare. Other central banks such as the European Central Bank, Bank of England and Bank of Japan joined the Fed in providing stimulus funding to revive their economies. Many other countries slashed policy rates, bringing them to zero or even below. Everyone knew that this could not go on forever, due to the excessive debt being accumulated by corporates, households and governments.

The other reason for unwinding the stimulus was to moderate asset prices that had been jacked higher by the easy money. Financial markets, on the other hand, have become extremely paranoid about monetary tightening. The violent reaction of markets during the ‘taper tantrums’ in 2013 and the decline in the last quarter of 2018 are cases in point.

With equity market rallies being flaunted as a symbol of economic health by leaders, central banks have been unable to effectively move towards monetary policy normalisation. This, along with other factors such as elevated equity prices despite poor growth, large speculative positions funded indirectly by central banks, threat of recession in many advanced economies and slowing growth in others, set the stage for the ongoing market crash.

Central banks in a fix

Global central banks adopted two ways to ward off recession in 2008-09. Most of them, including the RBI, slashed interest rates to multi-decade lows and some of the larger central banks began quantitative easing. The Federal Reserve was the first to begin, in June 2008, making its balance sheet expand over four times by the end of 2014. The Fed was also the most mindful about the negative impact of the QE programmes and after giving adequate notice to financial markets, began reducing its balance sheet as well as hiking rates from 2015. The Bank of England too tried to follow the Fed’s footsteps. The ECB and the BOJ however found it much harder to stop their stimulus funding or increase rates due to slow growth and very feeble improvement in inflation.

The Fed, too, had to succumb to pressure from financial markets and the POTUS, and after pausing its rate hikes for few months, it began cutting rates again in June 2019. It also resumed asset purchase in September 2019. This relaxation of monetary tightening in 2019, caused a fresh leg of rally in 2019 that was quite bereft of any fundamental mooring, in most countries. As market participants became more and more confident about the central banks’ continued support, speculative positions have also increased sharply in 2019.

Fallout of easy money policies

In its Global Financial Stability Report of October 2019, the IMF had stated, “The monetary policy cycle may have reached a turning point in major advanced economies, and the amount of global bonds with negative yields has reached almost $15 trillion.” These lower yields have been pushing institutional investors such as pension funds towards cross-border instruments which are relatively illiquid and bear higher risk.

Other issues highlighted by the IMF relate to increasing external debt due to higher liquidity in international markets. “Median external debt has risen from 100 per cent of exports in 2008 to 160 per cent in 2019. In some countries, this ratio has increased to more than 300 per cent.

A similar trend is observed in government debt, which is nearing 100 per cent of GDP in some countries.” US dollar assets of global non-US banks stood at $12.4 trillion by early 2018.

Besides these explicit effects, speculative positions have also been piling high due to easy monetary policies. According to the Bank of International Settlement, open interest in interest rate options increased 10 per cent in December 2019 to $61.5 trillion compared to December 2018. The World Gold Council has also indicated a surge in futures and options contracts in gold since the beginning of 2019. According to World Federation of Exchanges, total stock market capitalisation increased 22.85 per cent in the fourth quarter of 2019 compared to the same period in 2018, indicating a large inflow of money into equities as well.

In India, domestic mutual funds had been facing redemption pressures and had reduced their equity purchases, but foreign portfolio investors were firing on all cylinders last year; net purchasing $14.3 billion of equities in 2019.

Positions unwind

While the debt financed by central bank funds will begin to hurt only when these are rolled over, it appears as if the trading positions are being unwound now.

This is apparent in the manner in which the euro and the Japanese yen, the two popular currencies for carry trade, spiked over 5 per cent since February 20.

Due to the ultra-low interest rates and the ECB continuing to print notes, the euro had joined the yen as the preferred currency for carry trades over the last few years. Loans taken in these currencies are used to purchase assets across the globe or to take speculative positions in derivatives. Since stock prices collapsed suddenly after February 24, those holding derivative positions financed by the carry trades would have been under pressure to sell their positions to cut their losses to repay the loans. This is also the reason why the rupee, the US dollar and other currencies have become weak over the past few weeks.

What next

Everyone knew that assets prices were elevated due to access to cheap money and they also knew that there would be a shock once this crutch was taken away. Most were however hoping prior to February that the global economy would recover, helping central banks suck back the money pumped in through successive QEs.

The problem now is that it could be at least a month before the COVID-19 pandemic is contained in all the countries. With production and services getting shut globally, the IMF has warned that growth in 2020 could be lower than in 2019.

These concerns will continue to weigh on financial markets for some more time, exerting more pressure on those who have been conducting leveraged trading. It is therefore quite likely that the pain can continue for markets.

Central banks that have been in the forefront in providing stimulus funding may have few levers left at this juncture, given the already low interest rates and bloated balance sheets.

Other countries can, however, use a combination of monetary policy and counter-cyclical fiscal measures to support growth now. It is hoped that once this crisis blows over, the central bankers would seriously rethink their policies and make course corrections.

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