Masters of the universe — central banks’ grip on markets tightens
Since the global financial crisis, central banks have accumulated powers over regulation and supervision of markets as well as over monetary policy. In 2019 politicians began to erode that with interventions that have raised questions over who should control markets. By Phil Thornton
The independence of central banks came under unprecedented attack this year, as politicians embarked on populist policies that hurt their economies or refused to take measures to give them a much-needed boost.
Sometimes the political interference is blatant, as exemplified by US President Donald Trump’s repeated calls on the Federal Reserve to cut interest rates and his tweets threatening to remove its chairman, Jerome Powell.
He is not alone. Turkey’s president, Recep Tayyip Erdogan, has set out a novel theory that rate cuts lower inflation. His calls for lower interest rates even amid runaway inflation appeared to have been picked up by the central bank, which cut rates by 250bp in October.
On the other side of the world, Indian central bank chief Urjit Patel resigned after a public row with Prime Minister Narendra Modi’s government, to be replaced by Shaktikanta Das (who has since cut rates by 50bp). Indeed, according to the International Monetary Fund, central banks representing about 70% of world GDP loosened monetary policy between April and October 2019.
Then there are indirect interventions that hurt growth and force central banks to make even greater use of monetary policy, whether that it is the trade war launched by Trump against China or the pressure on Germany to provide a fiscal stimulus for the eurozone economy.
Tobias Adrian, financial counsellor at the International Monetary Fund in Washington DC, says even if central bankers do not respond to political pressure in the decisions they take, it changes the markets’ perception. “The public might have the perception that the central bank is in the hands of the politicians and at that point, trust can erode. That’s a real danger here.”
This erosion comes after 10 years of central banks accumulating more power and responsibility following the financial crisis. It fell to them to keep economic growth alive. The net result of this accumulation of power is that central banks have cemented their position as the masters of the universe with their quantitative easing policies and near-zero interest rates coming as they have been handed greater supervisory and regulatory powers. This means they have built up a very significant influence over financial markets.
“It is true that central banks have taken control of financial markets,” says Padhraic Garvey, head of global debt and rates strategy and regional head of research, Americas, at ING in New York. “Since the financial crisis, there has been greater control taken by central banks, which makes sense against a backdrop where central banks hold a massive chunk of government bond paper — whether that is the Fed, the Bank of Japan or the European Central Bank,” he says.
Central banks now hold vast stakes in many advanced economy sovereign markets. Major central banks’ holdings of domestic sovereign bonds range from 20% of outstanding domestic paper by the US Fed, to more than 30% in the UK and almost 45% in Japan, according to the Bank of International Settlements.
A BIS study of banks’ unconventional operations found that while the immediate impact eased severe market strains created by the financial crises, there had been several negative side-effects. These included a scarcity of bonds available for investors to purchase, squeezed tightening in some markets, higher levels of bank reserves and fewer market operators actively trading in some areas.
Garvey says central banks have contributed huge excess demand for sovereign paper that has left trillions of dollars earning negative yields. “When you are looking at the risk-free rates space, I would argue that that is quite deviant from the contemporaneous macro circumstances,” he says.
With central bank rates close to — or below — zero in many economies, investors have embarked on a search for yield, taking advantage of the huge quantity of liquidity in the financial markets. Equity markets and bond prices are at historic highs.
This has created a paradox: levels of volatility such as the Vix index have fallen close to record lows even as analysts fret about the potential for asset prices bubbles to burst.
This concern has been compounded by the fact that central banks have been given greater supervisory powers. The Bank of England and the European Central Bank gained financial supervision powers in the wake of the global financial crisis, while the Federal Reserve cemented its position as the primary supervisor of the nation’s bank holding companies.
“We are heading through a period of regime change, which has been a combination of central banks doing their own thing in terms of QE and ultra-low rates together with these rules and regulations that the banks and market participants have got to abide by,” Garvey says.
“Does that combination lead to greater volatility? Well, yes. Have we seen it? No. In terms of measures of implied volatility, the traditional market measures are starkly low and will remain starkly low.
“Having said that, is there a greater risk that we are going to have some outsized moves in markets.”
The fear is that this cocktail of masses of liquidity, ultra-low rates and a search for yield will manifest itself in the form of a financial crisis, whether through an asset bubble bursting or a so-called “flash crash”, where markets plunge precipitously at wholly unexpected moments before rebounding.
The crash in the prices of complex securities based on illiquid collateral of subprime mortgages in the US in 2007 and 2008 forced policymakers in Europe and the US to intervene by supporting markets and in some cases rescuing the financial institutions involved.
The first of 2019’s flash crashes came within three days of the new year, when the yen spiked suddenly against the dollar. It jumped 8% in the space of seven minutes against the Australian dollar and 10% against the Turkish lira. The second was in February, when the Swiss franc gyrated wildly, with an unexplained and brief jump against the euro and dollar.
In its April global financial stability review, the IMF said increased instances of flash crashes in recent years, even in the most liquid markets, had raised concerns about the fragility of market liquidity. It said there was a “liquidity strained event” in the sovereign bond market — its term for a lack of buyers and sellers — once a day in early 2019, up from about three a week in 2018.
The IMF has developed a monitoring tool that can help its analysts gauge whether liquidity conditions are becoming strained. Fabio Natalucci, deputy director of the monetary and capital markets department at the IMF in Washington DC, says that while it is currently looking at equity and sovereign debt markets, there are plans to extend it to more illiquid markets such as credit and complex securities, although data availability may be an issue.
“It is not to forecast liquidity events but to get a sense of whether the conditions are set for making the system more susceptible to some kind of shocks in terms of a liquidity amplifier,” he says. “Financial conditions are extraordinarily easy now, especially in the US and Europe, and there are a number of triggers that could generate a sudden sharp tightening of financial conditions and that could be amplified by a lack of liquidity.”
Regulation and reform
According to the IMF, tighter leverage and capital requirements for banks have arguably increased the cost of providing capital market services and changed dealers’ incentives to make markets — leading, for example, to some dealers cutting services to less profitable clients.
On the supply side, expanding central bank holdings of safe and liquid assets resulted, by design, in the reduction of the free float of securities available for investors. On the demand side, monetary policies nudged investors to reach for yield through exposure to duration and credit risk in less liquid assets, it said.
Adrian says increased financial regulation may have had unintended consequences in terms of making episodes of illiquidity more likely.
However, he insists the benefits of greater financial stability for tighter regulations outweigh the lower levels of balance sheet capacity. “The risk that a number of large institutions might go bankrupt is much lower than it was in 2008, but on the other hand smaller liquidity events might become more frequent.”
With interest rates forecast to stay lower for longer and the ECB still injecting liquidity, analysts believe markets will remain under the control of central banks for some time.
Garvey says the resolution will have to come through rising inflation that will allow banks to raise interest rates and withdraw liquidity, although he says the outlook is “remarkably benign” in Europe and the US.
“We have this great difficulty generating inflation,” he says. “If there were to be a generation of inflation in the eurozone, that would be the clearest route to exiting the negative rate environment,” he says.
The IMF’s Adrian says central banks need to ensure their policy frameworks are fit for purpose, pointing to the Fed and ECB as two banks that are rethinking them.
Holger Schmieding, chief economist at Berenberg in London, says there is not much else central banks can do. “They didn’t mess it up and they can’t do much about it. They can react to the symptoms, but they can’t solve the underlying political issues and the underlying nervousness of business, households and especially financial markets."