What does it take?

There are certain central banking events which have gone down in history. Sometimes the event was only momentous in hindsight, as with Ben Bernanke’s 2002 speech setting out the guidelines of what would later become the QE doctrine. Occasionally, as with Alan Greenspan’s “irrational exuberance” comments in December 1996, it was obvious at the time that something truly memorable had just happened. Another such event took place five years ago when on this day in 2012, Mario Draghi made his famous speech in which he promised that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

It was! Indeed Draghi deserves a lot of credit for keeping the show on the road against a backdrop which threatened to become utterly chaotic. His first act on taking over as ECB President in November 2011 had been to reverse the ECB’s misguided rate hikes earlier that year. But by summer 2012, the euro zone was experiencing an existential crisis with talk of Grexit high on the agenda. Draghi’s words helped calm a fragile market, and by subsequently stepping into the vacuum created by a lack of government clarity, the ECB did indeed do what was necessary. It pumped huge volumes of liquidity into the system and apart from a brief wobble in summer 2015, the euro zone has steadily moved forward. In the sense that Draghi’s goal was to prevent the euro zone from fragmenting, he very much did what was required. Indeed, today there is very much a sense of optimism surrounding the euro zone economy as sentiment continues to rise.

But the ECB still has its foot to the floor, buying huge quantities of government bonds as part of its QE programme and speculation is increasingly mounting as to when and how it will begin tapering its purchases. Meanwhile, the Federal Reserve has been through a tapering process culminating in a cessation of bond purchases, and has raised interest rates by a total of 100 bps since December 2015. Indeed, the Fed is actively discussing balance sheet reduction, so monetary policy normalisation is clearly underway in the US. Despite this, both the MOVE index of US Treasury market option volatility and the VIX index of equity option volatility have touched all-time lows on data back to 1988 and 1990, respectively (see chart). It may be summer, and trading vols have dwindled, but this does raise a question as to whether markets are too complacent. There again, what do markets have to fear?

Central banks have effectively anaesthetised bond markets in recent years and investors have piled into equities with impunity because (a) they don’t really have anywhere else to go and (b) they know that central banks will signal policy changes well in advance, providing them with enough time to get out. The ECB last week failed to give any hints at a policy change and is now effectively on holiday for the next month, and although there is a prospect that Draghi will try to steer market expectations at the Kansas City Fed’s Jackson Hole Symposium in late-August, the markets today seem to be in a mood to see action rather than words. Similarly, the Fed announced a steady-as-she-goes policy today, meaning that nothing will happen on the monetary policy front until September. The BoE may try to inject some volatility into the market following next week’s MPC meeting but it has limited scope to have a wider impact.

Do central banks now need to show that their bite is indeed as bad as their bark? The reason markets are idling along is an indication that they do not fear tighter policy. They should! Central bankers are aware of the dangers of allowing markets to become too complacent because the knee-jerk response in the event of an unanticipated shock will be all the more dramatic. This may explain why various BoE officials have tried to sound hawkish in a bid to jerk the markets into action. Markets may be able to live with the modest degree of tightening we have seen from the Fed so far. So long as interest rates remain low, a dividend discount model in which equity valuations are determined by the discounted value of future revenue streams, will continue to support current levels. But if the Fed starts to run down its balance sheet and put some upward pressure on global bond yields, the equity world may look different.

Unlike in 2012, words no longer appear to be enough. But my sense is that markets ought to take heed of the hints which central bankers are providing. Whatever some investors may think, central banks are not there simply to act as a backstop for market actions. If,  or when, the monetary policy cycle finally turns there is a risk that people might get hurt.