Peter Pan, Central Banks and markets

J M Barrie’s Peter Pan had a very strong grasp of the necessity of faith – “Whenever a child says “I don’t believe in fairies”, there’s a fairy somewhere that falls down dead” was written in 1911, and his own ability to fly was critically dependent on his lack of doubt that he could fly.

Ever since the introduction of QE in 2009, markets have had faith that the unconventional actions of the Central Banks would lead to economic recovery. The markets’ expectation of better times ahead itself played a key role in boosting confidence in the real economy, so helping to generate that recovery.

In the last three months however, that faith has been eroding as markets have come to believe that central banks are no longer in control of events. In Japan, the failure to boost QE further at the end of 2014, when the Bank of Japan were expected to do so, closely followed by the adoption of negative interest rates a week after denying they would do so looks like panic. In Europe, Draghi encouraged markets to believe that further ECB easing would be forthcoming in December, only to be unable to deliver it, and then repeated the encouragement that action would be taken in March after market weakness in January. The ECB appears to be a very divided Central Bank. In the US, the Federal Reserve clearly indicated in December when it raised interest rates for the first time in seven years that it expected four further such increases in 2016. Yet markets now assign an equal probability to their next move being a rate cut as a rate hike – the Fed is losing credibility.

Behind all this is the continued deterioration in growth expectations – a year ago there was a general sense that 2015 would see economic recovery around the world as the enormous global monetary easing over the previous six years finally bore fruit. The reality was that once again growth disappointed expectations even with the tailwind of a much lower oil price. Market sentiment is giving up on monetary policy producing economic recovery, and their lack of belief will make it even harder for Central Banks to deliver it.

In particular the move to negative interest rates in Europe and Japan, and the admission by Janet Yellen that the Federal Reserve would also do so if they believed it was necessary has alarmed investors in bank securities, both equities and bonds. Coming as it does with further downgrades to global growth expectations, markets have drawn the implication that central banks themselves are losing confidence that further QE will stimulate economies and thus they are moving towards the idea of negative interest rates. If the Central Banks no longer believe in QE, why should anyone else?

Widespread negative interest rates have not been adopted before – perhaps they will incentivise people to spend rather than save, but that is unclear. What is clear is that negative interest rates are bad news for banks – they have been very reluctant to extend negative interest rates to most depositors, with the result that their net interest margins are falling, at a time when loan growth is slow or non-existent. Banks are the worst performing equity sector so far in 2016.

Markets have now lost faith in the ability of Central Banks to create economic growth – falling bond yields and falling equity prices demonstrate this. To recapture that faith, Central Banks will have to take even more aggressive, unusual and unexpected action.