Are Central Banks Encouraging Risk Taking Behavior in Speculators…Oops…Investors
This has been an exciting week for markets and we have received a few interesting responses on our recent insight on 30th April related with ‘News Sentiment Impact’ on Markets Back in Business? which had also mentioned our 9th April insight on Fed Making Data On Fundamentals Irrelevant For Markets?
These writings had focused more on the dichotomy between fundamentals and market performance over last 6-8 weeks. More specifically about how the signals from fundamentals of economy (such as jobless claims) and their linkage with market movement.
On these insights, some readers have raised points like, a) what are the options investors have and they need to invest somewhere or other, b) the risk appetite is linked to market circumstances and when circumstances change, the perceptions also change. Some other readers have said that when Central Banks globally are responding with powerful monetary measures and the Governments are releasing massive financial stimulus in the system across the world, the 30% plus recovery in S&P 500 since 23rd March 2020 would not look that strange. More or less, this is the story across financial markets in the entire world.
Fig. 1: S&P 500 Index in last six months (Source: Google)
Another reader pointed out that this is closely linked to what has happened in the bond markets in US. The Federal Reserve had announced on April 9th that it would include lower-rated debt in its latest asset-purchasing program. The announcement was followed by billions of dollars of inflows into funds specializing in high-yield debt (this will be low quality, by definition). The Fed was also buying bonds which were downgraded and no longer investment grade. The European Central Bank adopted the same policy and effectively, the associated risk with more risky investments was artificially lowered by Central Banks.
What does it do? We think that the signalling mechanism by Central Banks is a very powerful tool how to change the risk perception by market participants. By these measures, when a Central Banker is telling investors that it is OK to indulge in high risk investments, investors would think like this: Yes, it makes sense. What I gain is mine and if lose something, there is someone to share these losses. So, let me add a little more of high yield, low quality investments. Effectively, Central Banks globally were lowering the risks on low quality (or in other words, financial assets which will be impacted more from Coronavirus pandemic crisis) investments. This is to a large extent has been a driving force for markets.
How long this can continue. In a way and theoretically speaking, this can continue forever or till the time people have faith in Fed or their respective central banks. But practically, the momentum will swing again when investors think that the rewards have become lesser compared to risks after the sharp run up in prices. How far we are from that point or have we already crossed it. No one knows but the belief is still strong that there is more firepower available with Fed and that perception alone can support the markets. Interesting few weeks ahead!
EM Alpha LLC
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