Opinion

James Saft

COLUMN: Revenge of the markets: James Saft

May 23, 2013

May 23 (Reuters) – For months, markets have been dancing to
central bankers’ tune, but that may now be changing.

It must have been fun to be a central banker in the early
part of 2013: You say “jump” and Mr. Market says “how high?”

That seems to have ended rather abruptly in the 24 hours
beginning with the Bank of Japan’s disappointing response to
bond market volatility on Thursday and including Ben Bernanke’s
anodyne but market-roiling comments on Wednesday on the
possibility of a policy taper.

Tokyo’s Nikkei tumbled more than 7 percent on Thursday,
European shares suffered their worst day in about 10 months and
even the perpetual paper wealth machine known as Wall Street
fell, with the S&P 500 down by as much as 1 percent before
leveling off.

The re-introduction of this kind of two-way risk, both for
markets and for policymakers, highlights some of the
difficulties of the heavy reliance on asset-pricing markets as a
policy tool.

“The tremors we have seen in stocks and currency markets
yesterday and today are a sharp reminder that while the Fed can
fine-tune its exit from QE, moving gradually and adapting to
economic developments, it cannot control the markets’ reaction,
which is likely to be a lot more sudden and disruptive,” said
Marco Annunziata, chief economist at GE in San Francisco.

“Market reactions are a lot harder to manage than inflation
expectations – no matter how careful the Fed is, the exit will
not be smooth.”

It all makes quite a contrast from the earlier part of the
year. Central bankers worldwide appear to have enjoyed rare
power and respect in financial markets, in some cases a function
of new policies, as with the Bank of Japan. But in others, like
the Fed’s, they have been pursuing the same policy all along.

The Bank of Japan, with strong support from the new
administration of Prime Minister Shinzo Abe, has successfully
inflated Tokyo share markets, while at the same time deflating
the yen.

The Fed, which has explicitly followed a policy of inflating
assets to generate economic growth, has enjoyed the support of
the metronome-like equity market, which has risen 13 percent so
far this year with little volatility.

Even the European Central Bank, which faces serious
structural issues in the single currency zone, has seen a
satisfying fall in effective sovereign interest rates, in part
because markets themselves have given full credit to Mario
Draghi’s “whatever it takes” pledge to defend the project.

SEA CHANGE OR DAY TRADE?

So was Thursday simply a bad day for markets, or does it
presage more difficult conditions for policy makers, the economy
and investors?

Japan’s situation is particularly complex. While the BOJ and
central bank head Haruhiko Kuroda paid lip service to concerns
about spiking interest rates, of note was that actual bond
buying didn’t stop 10-year JGB rates from hitting 1 percent for
the first time in two years. The BOJ launched a 2 trillion yen
fund supply operation, as well as two bond-buying efforts
totaling 810 billion yen.

The worry is that spiking yields will draw more speculative
bets, as well as potentially imperiling bank lending and capital
adequacy.

As for the Fed, there really wasn’t much in Ben Bernanke’s
congressional testimony or in the release of the Federal Reserve
minutes that should have changed minds in the market, but
nonetheless it did.

While Bernanke did say in answer to a question that if the
data merits, the Fed “could take a step down in the next two
meetings,” he also balanced that, as he has in the past, by
noting that premature tightening could slow or end the recovery.
He further gave no indication that he regards the recovery as
self-sustaining, thus making the promise, or threat, of an early
taper somewhat empty.

Of the two issues, in Japan and the United States, the
threat of rates in Japan is far more serious. Theoretically,
Bernanke can and will keep the bond purchases coming, thus
neutralizing and reversing a destabilizing market tumble. It is
the fact that markets in Japan were tumbling because its bond
market wasn’t reacting as wanted to BOJ purchases that is scary.

In the case of the Fed we can debate whether or not its
policy is having the needed economic impact without losing faith
in its ability to influence asset prices. In Japan, with its
heavy debts, the fear is that authorities are losing control in
a more profound way.

What is true in Japan has meaning everywhere, which is
perhaps the best explanation for the global sell-off.

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