Central Banks and Markets: Mind the Confidence Gap

The persistence of unconventional policy doesn’t seem to be boosting confidence among investors, even as it enriches them

By Richard Barley

EU flags outside the headquarters of the European Central Bank in Frankfurt at half-mast in July to commemorate the victims of the Bastille Day attack in Nice. Photo: Reuters


The usual relationship between central bankers and investors is that the former worry about the latter showing signs of “irrational exuberance.” Right now, though, it is investors who appear to be more worried than policy makers.

Repeatedly since the global financial crisis, central banks have mobilized in response to events that threatened to derail economies. The Federal Reserve has engaged in three rounds of quantitative easing; the European Central Bank has steadily ramped up its efforts to buoy the eurozone; the Bank of England is back in easing mode thanks to Brexit. Central bank balance sheets are only getting larger, and the spillover effects are being felt around the world.

Each individual response is understandable, but the cumulative effect is causing worry rather than exuberance. That is even as central-bank buying powers some markets to produce strong returns.

Take the European investment-grade corporate bond market as an example. At the end of 2015, return expectations were lackluster given the low level of yields. Citigroup C 0.32 % strategists forecast total returns of 1.8% for 2016; J.P. Morgan JPM 0.42 % analysts thought they would actually be negative.

The ECB’s corporate-bond purchase program has changed all that. It has driven yields to new historic lows, and in the process reduced funding costs to minimal levels. As a result, European corporate bonds have returned 6% year-to-date, according to Bank of America Merrill Lynch indexes.

Investors don’t appear terribly happy, however. Some complain about the way fundamental valuation is being subverted by the wall of central-bank cash; others fear the effects on liquidity. Deutsche Bank DB 1.43 % strategists say investors are being faced with a balancing act between an aging economic and financial cycle, particularly in the U.S., and “overwhelming” technical forces including central-bank buying. Citigroup strategists Monday put their concerns front-and-center in a presentation headlined “Please don’t buy so many bonds, Mr. Central Banker”.

This isn't to excuse all complaints from investors. They have no right to steady returns, nor to have investment decisions made easy for them. If investors feel aggrieved about central banks because their own funds are underperforming, that isn’t a good reason for criticizing policy makers.

But there are more valid worries. One is that while central bank efforts are proving enough to keep the economic show on the road, they aren’t doing more than that; the persistent downgrading of growth expectations and the constant refrain from policy makers themselves for politicians to take measures to boost growth sustainably are testament to that.

But, meanwhile, they are producing asset-price inflation. The fear is that the gap between asset prices and reality will close sharply as markets correct. It isn’t clear what might cause that or when: markets are still dancing to the tunes being played by central banks.

Unconventional policy in the immediate wake of the financial crisis undoubtedly helped to boost confidence in markets. But the longer unconventional policy persists, the less confidence it inspires.

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