Why Central Banks Should Surprise Markets [Published on July 2016]

Volatile financial markets, which is a by-product of uncertainty in fundamental signals in economics or politics, offer investors a rare opportunity to earn big money. However, the migration to what investors regard as ‘safe haven’ assets shed light on the risk-averse investment behaviors, especially due to the risks from ‘Brexit’ and the rise of Republican Nominee Donald Trump recently. For example, in the months leading up to and on the day of the ‘Brexit’ vote, the Japanese Yen outperformed against all other major currencies, and Gold has surged over 22% since January.

Long story short, volatility is not good in the eyes of policymakers. It makes investors cautious about risky assets (i.e. stocks) which reduce business investment, GDP growth, and wage growth. Central banks have traditionally played the role of leading and stabilizing markets through the use of Forward Guidance, a key Central Bank policy tool to announce the expected path of interest rate to traders and investors.

If you have read my previous article here, I argued that the advancements in the financial markets over time have partially displaced power from policymakers to investors. Large amounts of information have fundamentally changed investors’ behaviors from merely being responsive to speculative in the markets. Speculation involves making predictions; forward-looking investors make their investments today in anticipation of a favorable situation to which they could profit from in the future. The danger of speculation is that it could become manipulation; in effect, the market dictates the action of policymakers because any significant decision must be carefully evaluated against the economic indicators, and that includes signals from the markets.

Let us travel back in time to January 2016, during the first Federal Open Market Committee (FOMC) meeting. The US economy started the year strongly, with consumer spending, wages and inflation picking up from the previous quarter, suggesting the economy is robust enough to endure a planned rate hike in June. Flash forward several months to May, the bond market issues an ominous warning by a flattening of the yield curve depicted by the shrinking gap in yield between the 2-year and 10-year Treasury bonds in the graph below:

The flattening of the yield curve often coincides with a recession, however, economists were not worried about the impact on the U.S. economy, but the world economy. The market predicted that a rate hike in June would have a negative impact on world economies enduring sluggish growth and uncertain political landscapes, and priced the market accordingly. In the end, the Federal Reserve refrained from raising rates. Here are the two extracts from the Wall Street Journal that elaborates on this:

1. Favourable 2016 economic data - http://www.wsj.com/articles/u-s-growth-revised-higher-in-fourth-quarter-1456493673
2. Flattening yield curve - http://blogs.wsj.com/moneybeat/2016/05/24/signals-from-the-u-s-yield-curve-world-cant-handle-fed-rate-hikes/

It is important to note that speculative behavior may cause unintended effects for a country’s long-term policies through the markets. Policies, particularly for monetary, have become too predictable thanks to an increasingly transparent financial market in addition to the careful nature of policymakers gently nursing their economies back to health. Every country has autonomy over its policies to achieve its ideal economic situation. However, predictions cause speculation, and this may move markets in an opposite direction from what the state wants. Is there any method in which the Central Banks can prevent this speculative behavior?

Here is an interesting method: what if Central Banks were to intentionally surprise markets?

It is certainly a controversial idea, but it is not completely irrational. An element of unpredictability is necessary when markets need to be corrected to achieve policy targets. Compared to QE and negative interest rates, this is about as unconventional as it gets for Central Bank policy. We will do a case study on the Bank of Japan (BOJ) and the Yen. Below is a 5-year chart of the USDJPY (2011 - 2016):

One of the policies that Prime Minister Shinzo Abe advocated is monetary stimulus; under economic theory, the stimulus would make it cheaper to borrow, increase consumption and inflation, and depreciate the yen to make exports more competitive. When BOJ governor Haruhiko Kuroda took office in March 2013, he immediately surprised by announcing his plan to increase the monthly bond purchase program to 7.5 trillion yen and double the monetary base. Because the stimulus was greater than expected, markets took the news positively Yen depreciated very sharply by 8 percent, and continued to depreciate with speculation of further stimulus. This was a minor success in prime minister Abe’s economic goals to fuel export competitiveness.

However, three years of underwhelming economic data have changed the market’s mind, thereby signaling the Yen to reverse its downtrend. The Yen’s appreciation is exacerbated by its safe haven from the aforementioned risks. Kuroda surprised again at the beginning of 2016 by setting the benchmark interest rate to minus 0.1%. This time, the Yen fell on the announcement, but it did little to re-instill confidence in the BOJ’s easing policies to arrest deflation as it kept its asset purchase program unchanged. In this scenario, the aggregate effect did not exceed expectations and therefore did not alter the markets’ overall sentiment.

For Central Banks to influence markets it has to exceed market expectations through a ‘positive’ surprise. This particular case in the BOJ can be applied to the European Central Bank (ECB) when it cut rates and expanded QE in March 2016. Initially, the Euro fell over 1.6% against the US Dollar on the announcement but rebounded to end the day 0.6% higher after prospects of further stimulus is cut short.

One might sympathize with the Central Banks because it has been a scapegoat for scrutiny by investors that feel they betrayed their expectations to offer more stimulus. It also does not help when they continue to be at the center of attention because of QE and negative interest rate experiments. Clearly, the Central Bank cannot go at it alone; effective policy requires a simultaneous input from both fiscal and monetary tools. The coordination of both sets of tools has been disappointing. Mr. Mohammed El-Erian, the former CEO of PIMCO and a Bloomberg View Columnist, has continually expressed that well-constructed fiscal policy and structural reforms have been lacking.

Ultimately, the decision on whether to calm or jolt the market is hugely dependent on the macroeconomic effects that policymakers desire. The ideal weapon is coordinating fiscal and monetary policy together to convey a strong and confident message to the markets, but this is not always possible because of the ‘implementation lag’ between both tools. In light of this, the Central Bank should have the courage to occasionally remind the market that it is still a force to be reckoned with in an era where the effects of monetary policy are straying away from the forces of economics.

Sources:
http://www.bloomberg.com/news/articles/2013-04-04/bank-of-japan-boosts-bond-purchases-at-kuroda-s-first-meeting
http://www.bloomberg.com/news/articles/2016-03-10/ecb-cuts-all-rates-as-qe-boosted-to-80-billion-euros-a-month