Awash with cash, away with the fairies

Stimulatory monetary policy has hooked markets on cheap liquidity and and turned central bankers into dealers. Propping up markets in this way isn't sustainable.

Equity markets are bullish for the wrong reasons – because of stimulus from central banks rather than fundamental strength, according to Citi’s Matt King.

Through unconventional monetary policy, central banks have expanded their balance sheets by $US9 trillion over the past five years. It is a number so large it is impossible to find something tangible worth that much.

The direct result of monetary stimulus has been surging equity markets. This in itself is not a problem, but the justification for it is. In King’s words, who is the global head of credit products strategy at Citi, central bank stimulus is amazingly effective at propping up markets.

No wonder Wall Street is so infatuated with quantitative easing. The weeks the Federal Reserve doesn’t buy mortgage-backed securities or Treasuries, the market sells off. When the Federal Reserve buys assets, the market rises. This empirical evidence goes a long way to explaining why S&P 500 has gained in response to poor economic data as it supports the expectation quantitative easing will continue.

Beyond liquidity, a consequence of central bank asset purchases is the alteration of traditional supply and demand relationships. Due to central bank intervention in buying assets, there is more demand and less supply for other investors. Overwhelming demand is also working towards pushing up asset prices even further.

We now have a situation where markets have been pushed along at a faster pace than the broader economy, which brings into question financial stability. The central banker mandate generally focuses on inflation and unemployment, having little regard for overall financial stability. If this was the case, it surely would have been mentioned in the latest Federal Open Market Committee meeting minutes.

In the pre-crisis world, house prices were in bubble territory but inflation wasn’t out of control. So, in the eyes of central banks, there was no problem. As we know, it was the housing market that jump-started a wave of financial instability globally. Comments from King conclude central banks should pay more attention to house prices and the overall wealth effect created from a rise in this asset class.

As long as stimulative monetary policy is pursued, the fate of investment markets will be tied to the decisions of central bankers. It is a tough reality to swallow; they didn’t foresee the problems that landed global markets in this mess. Now we need them to guide the global economy through the next stage of a recovery.

The current environment is artificial as it is flooded with liquidity. According to King, the problem with this is the economy is significantly more fragile than investors realise, and asset prices simply aren’t sustainable.