So it has been a couple of weeks now and we have had the first Fed rate hike in 7 years. It has been a long wait and one that was eagerly anticipated.
The market reaction was dull. This is what happens when Central Bankers build expectations for months. We saw this with the end of QE, we saw this with Europe starting QE and now we saw it with the Fed rate hike.
Let me clarify what I mean by this. Before QE ended the Fed was repeating over and over and over again that they will stop QE entirely. At first the USD was rallying on the news. When the first trim in QE happened there was significant reactions to the reduction of Asset Purchases. However, as time went by and the Fed kept prolonging completely stopping QE the reaction of the USD became less and less. This was perfected to such a point, that when the Fed stopped QE there was virtually no reaction in the USD. This is only normal as markets are based around expectations and they attempt to discount for the future.
Let us take Europe QE as an example. The downfall in the EUR happened way before QE was announced. It was the intention of starting the QE program that was the big driver behind the EUR weakness. Once QE was announced the EUR fell from 1.15 to a 1.045. That is a 1050 pip move, however, less than half of the decline that the EUR experienced prior to that, from almost 1.4 to 1.15 or 2500 pips.
This is why when in December the ECB failed to announce further increases to the QE size the EUR rallied hard. The market didn’t meet the expectations it had build and it punished speculators by taking out stop losses.
Now, why am I saying all of this. While Central Bankers are rightfully attempting to diminish shocks to the financial system (in terms of volatility and so on) via communication and building in expectations they are failing to realize that this by itself is setting up a huge trap. By pampering markets like this and making trading & investment decisions a no-brainer they are creating a system that stops regulating itself. When markets don’t get what they have been expecting to get they start forcing the hand of central bankers which in itself posses systematic risk.
I am not talking purely in terms of asset prices on financial markets. The unintended effect of all this pampering is that when markets don’t get what they want they create big volatility. This big volatility goes through your average consumer. How you might ask? Via the media, via word of mouth and so on. People start becoming skeptical of just how effective are the already unprecedented policies by central bankers. They start saving more and consuming less. They are attempting to keep spending their hard earned cash strictly on things they need. This lack of consumption by itself leads to a decline not only in GDP & GDP expectations but also of inflation. This is where the dead spiral beings. Central banks nowadays are making inflation the main driver behind their forces. When they are pampering financial markets in an attempt to increase inflation expectations as measured by markets they are ignoring your normal citizen with no exposure on markets. However, it is your normal everyday person that makes inflation.
Thus one has to ask, wouldn’t it better if Central Banks weren’t so outspoken about their future policy moves in an attempt to protect financial markets from volatility? Currently financial markets are running Central Banks. They know the policy success of CB’s depends on their take on it, because in the end of the day it is a game of confidence. If markets loose confidence the whole economy follows simply because they have been led to expect too much and demand too much.
More updates coming soon.