I often speak of fundamental value as the tide that inexorably pulls prices toward it over longer time horizons, and waves as shorter-term developments that impact market and currency prices. One such wave is central bank activity (ultra-easy monetary policies), which has had a great influence on market and currency prices and should continue to do so.
Long before he was head of the U.S. Federal Reserve (Fed), Ben Bernanke determined that the best way to respond to a financial crisis is for central banks to expand their balance sheets. When he was Fed chairman, he followed that recipe step by step, to perfection. The United States was the world’s first central bank to expand its balance sheet aggressively.
Now, however, we’re seeing quantitative easing occurring not just in the United States, but across the world. The Bank of England (BOE), European Central Bank (ECB), and Bank of Japan (BOJ) have all taken on significantly stimulative monetary policies. Even the People’s Bank of China, through currency pegs, has done so too.
To give you a sense of what’s happening in these markets today, I’ve created a simple matrix that shows the four categories of securities that the big three developed central banks are buying or selling directly.
Because the BOJ is buying short- and long-term sovereigns, credit, and equity, it is actively engaged in directly influencing the prices of nearly every Japanese investment to which investors have access.
The ECB is manipulating markets nearly as much as the BOJ. It is buying and selling (mostly buying) short-and long-term sovereigns (because it has bought so many short-term sovereigns it can’t buy any more), and credit (because it was running out of sovereigns). The ECB isn’t buying equity.
Lastly, the Fed is buying short- and long-term sovereigns, but not credit or equity. It is also buying agency paper, which are securities, usually bonds, issued by U.S.-government-sponsored agencies and backed, but not guaranteed, by the U.S. government. That’s interesting, but doesn’t warrant a separate discussion here.
This means that a huge chunk of the equity and bond indices in which investors consider investing is being directly manipulated. And, there’s also an indirect influence on the markets: Even though the ECB and the Fed are not buying equities, equity prices are indirectly influenced to a significant degree through these monetary policies.
A huge chunk of the equity and bond indices in which investors consider investing is being directly manipulated by central banks.
This central bank activity is creating some big waves, without much foresight. If you look at the Fed’s dot plot—the part of the projections released along with its policy decision statements, which show where each meeting participant thinks the federal funds rate should be at the end of the year for the next few years—you realize that the Fed has no idea where interest rates are going.
And if the Fed has no idea where interest rates are going, far be it for corporations to figure out how to make long-term investment decisions and capital expenditures. It’s difficult for almost every investor today. Moreover, none of the central banks know how they will actually unwind their balance sheets when the time comes.
In order to invest in the assets the central banks are buying and selling, we need to know what fundamental value is. Fundamental value stills exists, but to understand it, we have to understand what central banks are doing, and more importantly, how the market perceives what central banks are doing.
Because, as legendary hedge-fund manager Stanley Druckenmiller said, the central banks may not have an exit plan, but the markets sure do.