QE has clouded market vision on what is normal
John Plender
Changes in policy are often accompanied by market disruption, writes John Plender
As market expectations on the timing of the long-predicted rise in US interest rates have swung wildly back and forth in recent months the Federal Reserve has been excoriated for bungling its communications.
Interesting, then, that San Francisco Fed president John Williams has rubbished the critics, saying that during the Federal Open Market Committee's years of inaction on rates the markets had lost what he called their "muscle memory" for responding to Fed statements.
Memory (and forgetfulness) certainly play an important part in the valuation of financial assets. So could he be on to something?
Yes, but the blame for miscommunication, in this case, should surely be shared. The central bankers' constant refrain that their actions are "data dependent" is a euphemistic way of saying that since the financial crisis they have had precious little grasp of how the economy actually works.
The distortions wrought in the markets by the central banks' own unconventional measures such as quantitative easing also mean that investors and traders, over-trusting the ability of central bankers to fix the economy, are likewise unsighted. This is emphatically not the market of the economic textbooks - or of central banks' economic models - in which prices are moved by the rational expectations of experts. Rather it is a case of the blind leading the blind.
At times the markets seem to be driving the central bankers, as in September when an unexpectedly dovish Janet Yellen, chair of the Federal Reserve, warned that developments in the global economy and markets might restrain US policy. Since then the Fed has been back in the driving seat, with successive governors leaving little doubt that it would take something huge and unexpected to prevent the FOMC raising rates at its next meeting in December.
Given the near universal consensus that there will indeed be a quarter-point rise next month and that subsequent monetary tightening will be much slower than in the past, will this rate rise be the most needlessly overhyped in living memory? It is hard to see anyone changing behaviour in response to a minuscule hike that has been so loudly advertised in advance. Nobody appears rattled any more by the leakage of capital from emerging market funds, which would be vulnerable if a rate rise caused the dollar to appreciate, thereby inflating emerging market countries' dollar- denominated debt.
In fact, the difficult questions for investors may be more about the long-term than the short-run impact of a rise. In a recent book Pascal Blanque, global chief investment officer of Amundi Asset Management, identifies parallels in the era of unconventional central banking measures with the dotcom bubble of 1996-2000.* This prompts the question of whether investors should buy or avoid QE-infected assets. And is it rational to buy because the central bankers are there as buyers of last resort?
This can be a career-threatening dilemma for fund managers because failure to buy may cause clients to depart, yet buying into the bubble is at odds with beliefs in the long term and in mean reversion. Because QE keeps volatility abnormally low, Mr Blanque adds, investors are vulnerable to spikes in volatility. At the same time, QE creates a false impression of liquidity and sustains fake alpha - market outperformance based on capturing risk premia on hidden fat-tails, or extreme, infrequent events.
His broader worry, like that of economists at the Bank for International Settlements, is that central bankers are trapped in a cycle of asymmetric policymaking that entails bubbles, busts and bailouts that engender yet more bubbles. This points to a decade in which monetary policy normalisation may prove impossible.
What is striking in all this is the extent to which the objectives and tools of central banking have changed. Where Paul Volcker in the 1980s battled to bring down rampant inflation, his successor Janet Yellen struggles to raise the rate of inflation to 2 per cent. The objectives now formally include financial stability, not just inflation and growth. And the tool box has been expanded to include QE and macroprudential policymaking.
Big structural changes in policymaking are often accompanied by market disruption. The central banks - and indeed the rest of us - are condemned to feel our way in the most opaque of worlds.
*Essays In Positive Investment Management, Economica, 2014.
