Central banks may be regaining some two-way control over global markets that had started to behave like a one-way bet. After flagging some unease earlier this month that frothy markets were assuming endless QE, the Fed and others look to be responding with at least some frank reality checks even if little new in the substance of their message. In truth, there may be no real change in the likely timing of QE’s end, or even the beginning of its end, but the size of the stock and bond market pullbacks on Wednesday and Thursday shows how sensitive they now are to the ebb and flow of central bank guidance on that score. Although the 7% drop in Japan’s stock market looks alarming – Fed chief Bernanke actually played it fairly straight, signalling no imminent change and putting any possible wind down over the “next few meetings” still heavily conditional on a much lower jobless rate and higher inflation rate. The control he gains from here is an ability to nuance that message either way if either the data disappoints or markets get out of hand.
The central banks are clearly treading a fine line between getting traction in the real economy and not blowing new financial bubbles. The decider may be inflation and on that score central banks have a lot of leeway right now – global inflation is still evaporating and, as measured by JPM, fell in April to just 2.0% – its lowest in 3-1/2 years. That said, CPI was also very well behaved in the run-up to 2007 credit crisis – it was asset prices and not consumer inflation that caused the problem. So – expect to hear plenty more cat-and-mouse on this from the central banks over the coming weeks/months.
For investors, periodic pullbacks from here are justified and likely sensible. But it’s still hard to argue against a wholesale change of behaviour – which is merely to assume central banks will prevent further growth shocks but will take some time to transform persistently sluggish growth into anything like a sustained inflation-fueling expansion . As a result, funds will likely steer clear of “safe” havens of cash, gold, Swiss franc and yen despite this bounce and continue their migration to income everywhere, with a bias to relative growth stories within that and an exchange rate tilt according to the likely sequencing of QE exit– all of which points to the U.S. dollar if not its stock markets. And for many that may just mean repariation or staying at home –the US is still the homebase for two thirds of the world’s institutional funds, or some $55 trillion of savings.
And the dollar move is just starting to play out big in emerging markets, where emerging market currencies are on the back foot everywhere from Turkey to South Africa, South Korea and others. The reaction so far as been to lift local stock markets on potential exporter relief but a big question moving ahead is to what extent persistent exchange rate weakness will start to deter or even reverse foreign investment flows.
Next week is a busy if mixed bag – a heavy G7 data slate, with Japan a focus; rate decisions in Brazil, Thailand, Hungary and Canada, US Treasury and JGB debt auctions, EU flash inflation and jobless reports, and China’s Premier visiting Germany.