Well, the BIS is out with its annual report which, in the past has provided quite a bit of comic relief thanks to the irony inherent in an organization whose board of directors is comprised of the world’s most powerful central bankers releasing long-winded diatribes warning about the dangers of central bank policy.
The most effective way to get through these tomes is to simply scan for charts and subheaders that look like they might be interesting and then kind of just insert yourself into the discussion midstream.
One of the interesting charts from the latest report suggests that, for all the talk about central banks rolling back accommodation and what impact that will ultimately have on risk assets of all stripes, politics has been moving markets more so than meetings chaired by BIS board members. Have a look:
So that looks like a rather stark juxtaposition and indeed SocGen’s Kit Juckes says it’s “possibly the scariest chart” in the report:
Possibly the scariest chart in the BIS annual report. Monetary policy consistently trumped by referenda/elections pic.twitter.com/16BbGVr763
— Kit Juckes (@kitjuckes) June 25, 2017
But I’m not entirely sure it’s apples-to-apples.
I mean, of course it’s not apples-to-apples, that’s the whole point (it’s monetary policy versus political events). But what I mean is that there’s something absurd on its face about comparing the election of Donald Trump and/or the UK Brexit referendum to anything else. Those events represented epochal shifts in the way we think about Western democracies. They will be enshrined in history texts. So I’m not sure it makes any sense to say “look! markets don’t care about monetary policy as much as they do political events.” It’s not “political events” in general, it’s those political events.
Still, a big part of the Heisenberg raison d’être revolves around the interplay between politics and markets, so it’s nice to see this type of thing acknowledged and discussed.
Further, what you’ll read below reinforces the idea that the rise of populism has created all manner of uncertainty and is more likely than not a destabilizing force, despite the inexorable rally in risk assets we’ve seen over the past year.
And indeed everything said above reinforces the notion that this has become central banks versus populism. While you can’t ignore the so-called “Trump rally,” you’d be remiss not to acknowledge the fact that it’s impossible to disentangle the central bank-inspired BTFD bid from “Trumphoria” – as it were. Additionally, to the extent Trump’s win created clear “winners” and “losers,” it likely contributed to the collapse of volatility (by driving correlations lower), thereby reinforcing carry trades and vol. selling, etc. etc. Again, impossible to disentangle.
Finally, do not that credit markets in Europe have essentially been forbidden from reacting to upsurges in populist sentiment. PSPP and CSPP have kept a lid on spread decompression around important political events. Again, it’s central banks versus populism.
Without further ado, here are some excerpts from the BIS piece…
From mid-2016 onwards, the improving growth outlook contributed to rising stock prices and narrowing credit spreads in major advanced and emerging economies (Graph II.1, left-hand and centre panels). As growth gathered steam, market volatility remained very subdued (Graph II.1, right-hand panel), even as policy uncertainty soared.
Within this broad picture, three phases defined market developments. From July to October 2016, initial signs of recovery and rising inflation started to boost advanced economy bond yields, while equity markets were subdued. In November and December, expectations of shifts in US economic policy sparked a rally in advanced economy (AE) equities and sharply higher bond yields, while weighing on some emerging market economy (EME) assets. Finally, in the first half of 2017, continued good news on growth supported AE and EME equity markets, even as long bond yields stayed range-bound, against a backdrop of quiescent inflation indicators and growing doubts about the prospects for large-scale US fiscal stimulus.
The three phases were demarcated by a series of political tremors. The first was the outcome of the UK Brexit referendum on 23 June 2016. Major stock indices in advanced economies fell more than 5% the day after the vote, and the pound sterling depreciated by 8% against the US dollar. Bond yields also fell initially, as investors reassessed growth prospects and the near-term monetary policy course for the United Kingdom and worldwide. But stock prices soon recovered globally. An initial widening of corporate credit spreads also reversed.
Politics delivered another shock to financial markets in November, with the unexpected US presidential election outcome. Stocks initially plunged on the results, but in a matter of hours began to rally on expectations of lower corporate taxes, higher government spending and deregulation. The S&P 500 index gained 5% from 8 November to the end of December, while the STOXX Europe 600 rose 8%. At the same time, returns diverged across sectors, as market participants sought to identify winners and losers from the incoming administration’s policies (Graph II.3).
Bond yields rose sharply after the election in anticipation of fiscal stimulus and a more rapid removal of monetary policy accommodation. The US 10-year yield rose from 1.9% on 8 November to 2.5% by year-end. The 10-year German bund reached 0.4% in December. Japanese yields did not increase much, however, turning slightly positive in November. Market commentary began to centre on a “reflation trade”, betting on an acceleration of growth and rising inflation in the advanced economies.
Higher yields reflected both higher expected short-term interest rates and rising term premia. Estimated term premia began to rise in the second half of 2016. While the US 10-year term premium turned positive in December, that for the euro area remained negative, at about -1 percentage point (Graph II.2, right-hand panel).
Global markets entered a third phase in the new year. Bond yields plateaued as the rise in inflation came to a halt and political developments in the United States raised doubts about an imminent fiscal expansion. Policy remained accommodative in the euro area and Japan, and long bond yields remained range-bound. The US 10-year yield fluctuated between 2.3 and 2.5% in the early months of 2017, before falling to 2.2% by end-May. The German bund stayed within a 0.2-0.5% range, and the corresponding 10-year yield in Japan remained below 10 basis points. The dollar lost ground, as yield differentials narrowed and the debate over fiscal and trade proposals continued.
A series of electoral results in Europe reassured markets in the first half of 2017. European stocks outperformed the S&P 500 in the days following the defeat of Eurosceptic parties in the Dutch elections in mid-March. In late April and early May a similar outcome in the French presidential election sparked a rally in equity markets and a broad-based strengthening of the euro. The French election result also reversed part of the previous widening in intra-European sovereign spreads that had stemmed from political worries and concerns about non-performing loans in some national banking systems (Graph II.8, left-hand panel). The outcome of the UK parliamentary elections on 8 June, however, added another note of uncertainty to markets.
Underlying a number of these changes was a shift of market participants’ attention away from monetary policy and towards political events.
During much of the post-crisis period, markets had focused on central bank policies as the key driver of asset returns. In the past year, however, the impact of monetary policy decisions and announcements on bond yields (as well as other asset prices) was relatively modest (Graph II.9, left-hand and centre panels). Instead, election and referendum outcomes led to sharp market adjustments (Graph II.9, right-hand panel).
A greater focus on politics also influenced return correlations across asset classes – the first indication of a shift in the pricing of risk in financial markets (Graph II.10). This was particularly visible in equity markets. For instance, in the weeks following the US presidential election, market participants saw the financial sector as a winner from less regulation and higher interest rates, and import-intensive sectors as losers from a more aggressive trade policy. These sectoral patterns shifted over the subsequent months, as priorities changed and markets reconsidered the prospects of success of various initiatives. Overall, however, a notable dispersion of sectoral returns translated into a decline in correlations. Asset return correlations across regions also saw significant shifts, for much the same reasons.
The sudden decrease in correlations reversed long-standing market patterns. For much of the post-crisis period, in times of increasing confidence, prices of “risk-on” assets (stocks, corporate debt, commodities, and EM debt and currencies) had tended to rise and those of “risk-off” assets (sovereign debt of the large economies) to fall, with the opposite occurring when market participants became less confident. In the course of 2016 and the early part of 2017, such uniform behaviour gave way to more heterogeneous responses.
One important factor in the “risk-on”/”risk-off” dynamics had been the influence of large advanced economies’ monetary policy on investors’ risk appetite worldwide. Market participants frequently engaged in parallel trades, buying and selling risk across industries and regions on the basis of perceived central bank intentions and expectations of continuing highly accommodative monetary conditions. In the period under review, politically driven developments in other policies played a greater role, contributing to the fall in correlations.