Make no mistake, the writing has been on the wall for quite some time and we haven't been shy about pointing it out.
Central banks are losing control.
Trillions upon trillions in post-crisis asset purchases haven’t given the global economy the defibrillator shock the world’s central planners were depending on to bring about a sustained and robust recovery.
Indeed, the opposite appears to have materialized.
Subdued demand and trade looks to have become structural and endemic rather than cyclical and rather than create "healthy inflation", seven years of accommodative monetary policy has only served to bury the world in a global deflationary supply glut. And that’s just the big picture. The more granular we get, the more apparent it is that central banks are no longer in the driver's seat.
Inflation expectations across the eurozone have collapsed despite Mario Draghi’s best efforts to assure the public that PSPP has been an overwhelming success and similarly, inflation expectations have tumbled in the US ahead of a expected rate hike which looks less likely by the day. Meanwhile, in Sweden, the Riksbank has sucked so much high quality collateral from the system that QE has actually reversed itself, giving the world its first look at what happens when QE demonstrably fails. And let’s not forget Japan, where the world’s most hilariously absurd example of central bankers gone stark raving mad has done exactly nothing to pull the country out of the deflationary doldrums.
And so here we stand, on the precipice of crisis with central banks having run out of both ammunition and credibility. In short, it’s time to ask if central banks have officially lost control. For the answer, and for the "QE end-game decision tree", we go to BNP.
Note that if CB's do lose it, the likely scenario is: "deflation, vicious cycle... economic depression".
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Not "IF" but "WHEN central banks lose control?"
The global financial repression pushed investors to invest cash in risky assets, such as property and equity. The scale of global policy interventions is trumping all fundamental factors for now. Investors should keep in mind that the road is never straight and next month should be full of potentially disruptive events impacting sharply overcrowded assets and trades. History shows that such misallocation of resources creates bubbles that can last before fully blowing; the question is not if, but when.
Risk assets and risk parameters would be massively affected in the event central banks lose control; in the meantime, EDS Asia believes that central bank maturities that use forward guidance matter more than the QE process itself. The Fed and the ECB have been providing guidance which partly explains the low short-term volatility. The BoJ is moving toward this behaviour, managing the news flow: therefore there is a case for the NKY index going up slowly with a lower upfront volatility and a term structure closer to the US one: in that sense, we have started to observe an "SPX-isation of the NKY Index" in the past few months before this summer’s risk-off, as short dated volatility was trading lower. In China, the PBoC intervention learning curve is steep; this is the reason we believe the next equity leg up will be accompanied by an elevated volatility regime.
The quantitative easing started in the US more than six years ago and the SPX index, as well as selective risky assets, are now hovering at the high end of their valuation histories. Recent price actions are testimony of the fragility of imbalances built over the years. Investors may recall the Japan easing experience in 2005 and 2006; an early exit, together with a global financial crisis, caused a Japanese equities meltdown (between mid-2007 and late-2008).
In the decision tree, EDS Asia addresses the potential "QE end-game scenarios" [attempting to] answer the question "Are central banks losing control?" and providing a time horizon and probabilities affecting each path, which should allow investors to get a clearer overview.