Why Central Banks and Markets Are Getting Out of Sync

Markets have had a string of misjudgments about central bank actions, a worrying development

By Richard Barley

   The Bank of Japan shocked investors by introducing negative rates in January, and then shocked them again by standing pat in April. Photo: Reuters


The world’s central banks have a wealth of concerns to address in the coming months. A new item on the list: their own actions, which are increasingly surprising markets, causing rather than easing volatility. With bond and stock valuations stretched, and policy perhaps becoming even more creative, that is a worrying development.

There have been a string of misjudgments by markets lately. Take last week’s decision by the Bank of England to leave rates on hold at 0.5%. Investors had expected a quarter-point cut.

When the BOE didn’t deliver, markets were volatile: the pound swung in a 3.7 cent range against the dollar over the day, according to FactSet, a big move.

U.K. markets aren’t alone. The Bank of Japan 8301 -2.70 % shocked investors by introducing negative rates in January, and then shocked them again by standing pat in April. The European Central Bank last December failed to deliver on admittedly sky-high expectations for an easing package, sending the euro up 2.9% against the dollar in its biggest one-day move in the last year.

The U.S. Federal Reserve hasn’t delivered a real shock decision, but market expectations of action have moved sharply to and fro; investors have been unsettled by relatively rapid changes in tone, as well as the Fed’s shifting attitude to global risks. Assumptions that the Fed is on hold could yet be tested, especially after Friday’s strong consumer spending data.

 

More vital decisions lie ahead for all four central banks, and the potential for gaps between market expectations and central bank reality appears high. Past misreadings carry a cost, as they may color investors’ interpretation of future actions. Policy options seem to be becoming extreme after a long period postcrisis in which they were more incremental: witness the debate about helicopter money in Japan.

That long period had contributed to a consensus that central bank policies were acting to damp volatility in markets; but now shocks are on the increase. And the ties between markets and central banks have never been closer. The ECB, for instance, is now buying a dizzying array of fixed-income securities ranging from government bonds to corporate debt to asset-backed securities.

Meanwhile, central bankers are sending out mixed messages. At the same time as pledging in various ways to do whatever it takes to prop up economies and protect financial stability—with the BOE’s Andrew Haldane calling for a “muscular” policy package to deal with the fallout from Brexit—many are also arguing more forcefully than ever that monetary policy isn’t the answer. They are right to do so, but markets don’t seem to be listening.

Indeed, markets appear simultaneously addicted to never-ending stimulus and doubtful about its effectiveness and capacity to cause damaging consequences. The timing and trigger for a reassessment of this balance are unclear. But that looks like a contradiction that will need to be resolved, with potentially messy consequences for investors.

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