Central Banks’ Shock Therapy Has Investors on Edge
Policy makers had a habit of delivering surprises that jolted markets during 2015
By Tommy Stubbington in London, Min Zeng in New York, and Lingling Wei in Beijing
Behind the biggest market meltdowns of 2015 were familiar culprits: central banks.
And more volatility is likely to follow in 2016 as investors navigate the Federal Reserve’s gradual exit from easy-money policies after the U.S. central bank raised rates for the first time in nearly a decade.
From the Swiss National Bank ’s shock decision in January to abandon the Swiss franc’s link to the euro, to the European Central Bank’s disappointing stimulus package in December, a series of central bank decisions have provoked extreme market reactions. In between, the decision by China’s central bank in August to weaken the value of its currency fueled fears about the state of the Chinese economy that spurred a global stock selloff.
The bouts of turmoil highlight markets’ growing reliance on the words and actions of central banks in the years following the financial crisis. Rock-bottom interest rates and massive asset purchases designed to kick-start ailing economies have encouraged investors to push into ever-riskier assets in search of returns. That has left many markets vulnerable to sharp reversals when popular trades turn sour.
“This year was a sign of things to come, and it will probably get worse before it gets better,” said Paul Lambert, head of currency at London-based asset manager Insight Investment.
“Central bank policy has pushed many investors beyond their comfort zone. Now we’re seeing the consequences.”
Meanwhile, the ECB and the Bank of Japan continue to grapple with weak economies and low inflation that may force them to ramp up stimulus. Japan’s central bank jolted markets when it announced a modest expansion of its quantitative-easing program on Dec. 18, initially boosting Japanese stocks before they turned sharply lower.
“I think 2016 will be quite challenging for central banks,’’ said Stephen Jen, managing partner at SLJ Macro Partners LLP and a former economist at the International Monetary Fund.
“This is like an 18-wheeler trucker not being sure when and where to turn, but has promised the world that he would use the turn signal in ample time.”
Compounding the problem are tighter regulations that have limited investment banks’ ability to trade large quantities of stocks, bonds and currencies. For investors, that means less liquidity—or the ability to buy or sell assets without moving prices appreciably—and wild market swings when a central bank delivers a surprise.
“Investors are vulnerable to more episodes like these in the future,’’ said Zhiwei Ren, managing director and portfolio manager at Penn Mutual Asset Management Inc., which has $20 billion in assets under management. “Central bank actions have been fueling volatile trading, and in the current low-liquidity environment, holding a crowded position is a recipe for disaster.”
On Jan. 15, the Swiss franc rocketed by more than 40% against the euro after the SNB abruptly removed its cap on the currency’s value—the sharpest one-day move for a major currency in more than 40 years of floating exchange rates. The SNB had been intervening in markets to prevent the franc from climbing too far and hurting Swiss exporters, but threw in the towel after growing uneasy with the enormous pile of euros it had bought. The decision caught out many investors who had bet on a falling franc.
December brought another bout of whiplash for currency investors that spilled into stock markets. The euro climbed more than 4% against the dollar after the ECB delivered a smaller stimulus package than many had expected. The surge—a massive daily move for euro-dollar, the world’s most heavily traded financial instrument—was just the latest in a series of sharp swings in 2015 as investors tried to second guess the rate at which ECB and Fed policy were headed in opposite directions.
The episode highlights another issue for major central banks: how to guide market expectations in a time of uncertainty.
In China, monetary-policy makers caused several rounds of market gyrations this year, as investors struggled to interpret signals from a central bank that often fails to clarify its intentions.
The People’s Bank of China, together with other Chinese regulators, helped fuel an epic run-up in share prices early this year, only to contribute to a dramatic stock-market crash over the summer through a series of conflicting messages. The slump wiped out $5 trillion of value in June and July.
The central bank was then front and center in an unprecedented government effort aimed at propping up share prices, pledging to provide unlimited liquidity to aid stock purchases by state companies.
As stock investors were still licking their wounds, the central bank stunned the world with a devaluation of the Chinese yuan in mid-August. The PBOC said the move was intended to bring the yuan’s value more in line with market expectations, but the surprise action triggered a sharp selloff of the yuan and the currencies in some of China’s trading partners. Many saw the devaluation as an attempt to shore up China’s export sector and a sign that the country’s economy was slowing more sharply than thought.
If China is serious about its push to open up its financial markets and internationalize the use of its currency, “improving PBOC’s communication with investors is very important,” said Puay Yeong Goh, a senior economist at Neuberger Berman, an investment-management firm in New York.
The tumultuous year has left many investors wary of the risks of placing too much faith in central banks.
“Credibility, or rather confidence in central banks has diminished,’’ said Jim Caron, global fixed income portfolio manager at Morgan Stanley Investment Management, which had $404 billion in assets under management at the end of September. “The consequence is that they may not be able to stabilize prices as effectively as they have in the past.”
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