What we have here is a failure to communicate

Until two months ago, financial markets had enjoyed a relatively long period of calm, engendered by global central bank policies of zero, or lower, interest rates and rolling quantitative easing programs. Obviously, as one can plainly observe, markets have been volatile over the last two months; more volatile than any time in the last four years.  

This has occurred neither because the global economy is slowing to a crawl, nor that China will suddenly find itself in a recession. It is being caused mostly by uncertainty, and financial markets do not like uncertainty. Just as financial markets can be calmed by central bank policy, central bank indecision and miscommunication can also be the drivers of uncertainty and the volatility that ensues. In the summer, we saw examples in both of the two largest economies in the world. 

There is a relatively under-followed mainland Chinese market called “China A Shares” that was, until Aug. 11, merely a curiosity. China A shares are virtually a closed market to anyone outside of China. In rough terms, from June 2014 until June 2015, the China A Share market increased by 110 percent, at which point the People’s Bank of China (PBoC) decided that they had a bit of an asset bubble on their hands. Through a variety of bungled efforts to take some of the froth from the market, they managed to organize a correction of -23 percent from mid-June until Aug. 10. The PBoC then decided it would be an opportune time to surprise the market and allow a 2 percent re-valuation of the centrally controlled band that their currency, the yuan, trades in.  

Poor communication around the reasons for the re-valuation essentially provided a match that hit the gasoline they had already thrown on the A Shares market. Suddenly, financial markets decided that China A Shares were the canary in China’s proverbial coal mine and China was doomed to economic hard times. We are being slightly bombastic there, but markets are fragile and prone to corrections of large magnitude from odd triggers, and this was no exception. China is in the process of transitioning from a manufacturing-based economy with a very poor method of debt, capital and resources allocation to a slower, but more stable and better allocated economy with a deeper capital market.  

That transition was always going to be difficult enough without the central bank getting in its own way. 

As the China “trigger” spread to a more generalized developed market equities correction, it was the U.S. Federal Reserve’s turn to get into the action. The Greenspan, Bernanke and Yellen Feds have been well known to ride to the rescue of equity markets when retirement accounts are starting to look a bit scary. This has been executed through QE programs, rate cuts, strong language or any combination of the above. As the U.S. Fed decided in September not to deliver its first rate increase in more than nine years, it too injected uncertainty into financial markets at a time they least needed it.  

The Fed had spent the last 12 months carefully preparing the financial markets for a normalization of rates and then, perhaps predictably, demurred due to global concerns. To quote Janet Yellen, the chief economist of the nation, at her press conference, she cited “the drop in equity prices, the further appreciation of the dollar, and a widening in risk spreads” as elements that they [the Federal Open Market Committee] were concerned about. Together with what she categorized as a weaker global growth backdrop, these changes “may restrain U.S. economic activities somewhat.”  

Those statements are not consistent with the message the Fed had been delivering right up until the September meeting. Their message was that the U.S. economy was doing well and that as far as U.S. domestic growth and employment were concerned, there was an unambiguous case for beginning to normalize policy. 

Mrs. Yellen sounded concerned, not confident, and that uncertainty fueled continued volatility. 

Over the next few months, we will see whether the Fed can get comfortable enough to begin to normalize policy. Recent speeches from the cast of characters at the Fed have been supportive of a 2015 hike, but very recent economic data has been decidedly mixed.  

Increased volatility was always probable in the second half of 2015, with a return to more divergent global central bank rate policy, but the PBoC and the Fed have injected more uncertainty when surely their job is to create a stable environment for assets to trade inline with their fundamentals. 

 

Disclaimer: The views expressed are the opinions of the writer and while believed reliable, may differ from the views of Butterfield Bank (Cayman) Ltd. The bank accepts no liability for errors or actions taken on the basis of this information.  

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Janet Yellen, chair of the U.S. Federal Reserve, left, speaks with Mario Draghi, president of the European Central Bank, during last year’s Jackson Hole economic symposium. – Photo: Bloomberg
Bloomberg

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