July 5, 2013 5:35 pm
Stocks feel heat of central bank battle
Jawboning is one of the more subtle tools in a central bank’s armoury. But the European Central Bank and the Bank of England deployed it to effect this week.
On Thursday the two central banks for the first time explicitly promised that interest rates would stay low for a long time, so-called “forward guidance”.
Their unusual and apparently uncoordinated verbal intervention was aimed at countering the recent rise in bond yields. That was triggered by the US Federal Reserve’s plans to reduce and then end its own “quantitative easing” programme – seen as posing a risk to fragile recoveries in the UK and Europe.
Analysts hailed it as a “historic event” in central banking and the initial investor reaction was unambiguously positive. Equities and bond markets rallied, and the euro and sterling tumbled against the dollar. In effect, the ECB and BoE got some of the pop of QE, without buying a single security.
“The market’s reaction clearly showed that investors did not expect European central bankers to be so bold, so soon,” says Myles Bradshaw, a portfolio manager at Pimco.
But the rally in stocks ended abruptly on Friday, when robust employment numbers in the US bolstered expectations that the Fed will scale back QE. This once more roiled bond markets, and erased some of the gains made by European and UK equities.
The swift reversal underscores how tricky it will be for the ECB and the BoE to shield the European recovery from the effect of changing monetary policy in the US. For all the tools at their disposal, the Fed remains in effect the world’s most powerful central bank, and few countries will be able to escape the effect of rising Treasury yields.
Strategists and investors predict that the push and pull of disparate central bank policy will be a defining feature for markets in the coming year. “This highlights the new battle ground for central banks in Europe, namely to fight the market’s reaction to QE tapering,” Citigroup analysts said.
Many remain optimistic that the ECB and the BoE will succeed in at least partly “decoupling” their monetary conditions from the US. The forward guidance was robust and clear, and could be followed up with more concrete steps, such as restarting QE in the UK or moving to a negative deposit rate in the eurozone.
“It reinforces that the UK, Europe and the US are in very different stages of their cycles,” argues Nick Nelson, head of global equity strategy at UBS. “We’re not immune [from the rise in US rates], but we can have some nuances.”
The positive impact may be greatest through weaker currencies. While European and UK shares and bonds lost ground after the strong US employment data on Friday, the declines in the euro and sterling deepened further.
Many strategists and investors expect this trend to continue. Buying the dollar has been one of the most popular trades in the global currency market this year as investors have bet the US economy will pull away from its developed market counterparts.
Investors say that this week’s action by the ECB and BoE could make shorting the pound and euro against the dollar an easier trade.
Currency investors are also pleased to see some firm differentiation between central banks on future interest rates. Trading currencies on diverging interest rates has traditionally been a key way of making money – but that has been harder in recent years as most major central banks have moved in the same direction, to lower interest rates.
“We’re setting ourselves up for a world that has a lot more divergence in it,” says Matthew Cobon, a fixed income and currency investor at Threadneedle. “For someone who’s strategically dollar bullish that’s a welcome sign.”
Equities should also benefit from weaker currencies. A strong dollar is particularly good news for companies with US revenues, it helped the FTSE 100 keep most of its gains on Friday. But a weaker euro and sterling “will help all exporters”, Mr Nelson points out. “This is clearly good for equities.”
Nonetheless, some fund managers remain cautious. They point out that European central banks are more dovish due to the diverging economic outlook: the US is recovering but the UK and European economic outlooks remain gloomy – hardly a fillip for stocks.
“A relaxed monetary policy is a positive for equities but at the same time you have to be careful because this is a confirmation that economic growth isn’t there,” notes William Davies, head of global equities at Threadneedle. “The worst is if you have an economy which isn’t recovering strongly and rising rates.”
Underlining the challenges facing the eurozone in particular, German new orders fell for a second month in May, revealing weaknesses even in the continent’s strongest economy. If bond yields also continue to climb, the ECB’s Mario Draghi and the BoE’s Mark Carney may well need to go beyond mere jawboning.
Copyright The Financial Times Limited 2013
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