Big decisions for central bankers amidst the blood-letting......

Tuesday 25th August 2015

Big decisions for central bankers amidst the blood-letting......

 All media outlets, everywhere.

We can take it as read that all will be aware of yesterday's crash in world stock markets, when Shanghai's fall of 8.5% led other markets across the globe to record their own eye-watering losses. We need to remember the conditions in which events occurred. Markets always overreact, and never more so than in times of panic-induced sell-offs. Moreover, computer-driven trading decisions often ignore what might be seen as common sense valuations and even thinner August liquidity only adds to the problem. Nothing could illustrate the point better than yesterday's low tick on the Dow Jones, down 1000 points on the opening before staging a partial recovery to more realistic levels. Shanghai is down another 7.6% today but European markets are higher, which might suggest that the panic has at least momentarily abated, but of course the big question for investors is whether this is developing into a fully-fledged crash or a manageable correction. The big question for central bankers is what to do to ensure that it's the latter.

 

China's authorities are learning some harsh lessons. By common consent, they've employed some pretty shrewd advisors to help them steer a steady path since China became the prime engine for global growth, but their inherently contradictory concept of state-controlled capitalism has always looked flawed in the long run. To say that recent policy now looks clumsy is an understatement. The plan to positively encourage a stock market bubble (to allow corporate debt to be converted into equity etc) was reckless. Then to believe that it was possible to support a market under intense selling pressure for any length of time through state intervention was naïve at best and now looks like a gross miscalculation. China has ignored one of the most basic realities  --  YOU CAN'T BUCK THE MARKET  --   probably in the belief that the enormous resources at their disposal meant that they're not subject to the normal rules. It looks now as though the view has been taken that the cost of supporting the market is too high, and stocks have been abandoned to find their own level. That's the trouble with intervention, or one of them at least : if you set yourself up to defend a particular level, once that level is breached there's hell to pay.

What steps can the People's Bank of China take now ? They don't have all the courses of action open to them that other central banks have, but further aggressive monetary easing is being called for. And therein lies the dilemma : the PoBC is involved in another hugely expensive intervention programme, that of supporting the value of the yuan from "over-depreciation", ironically a situation created by the PoBC's own move to engineer a (minor) devaluation on August 11th. Easier monetary policy would plainly work directly against the efforts to defend the currency, and something's got to give.

 What about the US Federal Reserve, and its decision on when to raise rates ? Hawks would remind us that the Fed's brief is a domestic one, and that it is not their job to boost or even defend asset prices. Therefore, the strength of the labour market and it's implications for LONGER TERM inflation means that the Fed should still look to hike in September. Maybe it's our turn to be naïve, but surely it's inconceivable that the Fed will not pay attention to global markets in turmoil. Besides, the accompanying crash in commodity prices (especially oil) makes inflation concerns seem more than a little academic just now. Whatever the case, the futures markets now suggest the probability of a September hike has dropped down to just 24% (from (50%), and quite a few are even calling for the Fed to wait until March next year.

 One of the most interesting aspects of the lowering of expectations of a rate rise in September has been the weakening effect it has had on the US dollar. US$ / Euro has been above 1.16  --  it's only a few weeks ago that we were at 1.08 and people were talking about parity. Incidentally, a similar scenario can be seen in UK£ / Euro, and for much the same reason. A weaker currency will be welcomed in both the US and the UK, but if things don't reverse themselves pretty quickly what will be the effect of a stronger Euro on the Eurozone economy as a whole ? Even with the recent benefit of a weak currency, it's been struggling along at best.