Central banking is a tricky business.
A central bank – if it exists at all – should really just be there for emergencies. If the whole banking system looks like it’s going bust, the central bank steps in to tell everyone to calm down. Money will be supplied. The world will not end.
But central banks have gone way beyond that remit. Former Federal Reserve chairman Alan Greenspan is most to blame for the cult of the central banker. But the new batch – from Ben Bernanke to Mark Carney to Mario Draghi – have gladly embraced celebrity status.
Trouble is, they’ve been ‘fine-tuning’ the market for so long that they pretty much are the market.
That’s fine for as long as they’re pumping the market full of money. Prices go up, investors stay happy. But what happens when they decide they have to pull out?
No wonder Bernanke can’t seem to make up his mind what to do…
Bernanke keeps markets on their toes
Markets had just begun to get used to the idea of the Fed starting to wind down quantitative easing. Then last night, Bernanke back-pedalled furiously.
Suddenly, he’s worried about low inflation, and he thinks the recent strong jobs data overstates how well the economy is doing. And he said that if markets push interest rates up too much, the Fed will “have to push back against that.”
The ‘strong dollar’ trade reversed rapidly. The euro bounced from a low of below $1.28 to back above $1.31. The pound rebounded too, as did the yen, as did gold.
What’s it all mean? How are you meant to make any investment decisions against this backdrop? The last couple of weeks have demonstrated clearly that a central banker now literally only has to open his mouth to move markets, really quite significantly. Bernanke, Carney and Draghi have sent minor quakes across all asset classes, yet not one of them has actually touched an interest rate or changed their bond purchase plans.
You could go mad trying to predict or react to all this. It’s easy to start feeling that the markets are just a giant casino, and the croupier has his thumb on the roulette wheel.
But unless you’re a day trader – in which case you are almost certainly destined to lose money anyway, much as I hate to break it to you – you don’t need to bite your nails every time Ben Bernanke opens his gob.
Fundamentals – remember those? – still matter
Believe it or not, fundamentals still matter. The underlying state of the economy is what informs a central banker’s actions. Why is the Bank of England gearing up to print more money, or at least keep interest rates low forever? Because Britain is up to its eyeballs in debt.
The least painful way out is through steady, relentless erosion of the debt through inflation. And we certainly can’t afford for interest rates to rise. So the central bank will act to weaken sterling and keep rates low.
The Bank has to walk a tightrope, of course. So you’ll get moments where Mark Carney seems to be pulling back if the pound is falling too fast, or the gilt market looks like taking fright. But overall, the direction of travel is towards higher inflation and a weaker pound.
This is what the Federal Reserve is trying to do now. The critical difference between the US and the UK is the direction of travel.
I know that many people are sceptical of the notion of a US recovery – I’m not very enthusiastic about it myself. I don’t believe that America’s economy is particularly healthy, or that we’ll see a boom to rock the world on its foundations.
But if you compare America to most other places, it looks a lot healthier. Shale oil and gas might disappoint the most optimistic estimates, but they do help. The housing market may have had an over-exuberant rally, but at least prices have some sort of relationship with reality, unlike in Britain. The banking system may be fundamentally flawed, but it’s more functional than most of the rest of the developed world’s banking systems.
I’m not saying ‘buy America’ – I think it’s too expensive. What I am saying is that US monetary policy is set to get tighter, much as Bernanke might fight it all the way.
Why you should stick with Japan
So if we’re still fans of fundamentals, then what should you be buying now?
You probably guessed by now that we’re fans of Japan. And that’s not going to change. But for once, we’re not alone. The Bank of Japan is more upbeat on the Japanese economy than it has been in more than two years.
And Louis and Charles Gave of Gavekal (courtesy of John Mauldin) note that Japan is “the one market where it’s possible to find attractive valuations, accelerating economic activity and liquidity growth feeding off a Tour de France vitamin cocktail.”
As we explained recently, there are plenty of ways to invest in Japan.
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