Almost ten years of central bank quantitative easing schemes and falling interest rates have distorted asset prices, but perhaps, more importantly, it has changed investor behaviour. The lessons from the Great Recession and the ramifications for people on the less fortunate end of the socioeconomic ladder have not been lost on central banks. While central bankers often repeat lines such as ‘there are limits to monetary policy’, the Federal Reserve has consciously targeted a fuller level of employment. This approach is meant to counterbalance the disproportionate impact of boom and bust cycles on workers in low-skill jobs, who are much more likely to be out of work for a portion of the cycle and lag behind their contemporaries.
A fairer distribution of social outcomes is a laudable goal, but the implementation via monetary policy is not free from potentially damaging side effects. A key benefit of economic downturns is the proverbial ‘cleansing fire’, which destroys failing firms and leaves space for new growth in the coming expansion. As we approach the longest economic expansion in history, not only has no fire occurred, but central banks have installed a sprinkler system. The prospect of perpetual growth, falling borrowing rates, and diminishing likelihood of a downturn have all caused a repricing of risk. To put it more directly, when rates are forever falling towards zero, and the central bank will always defend the economy against a downturn, why not pile into assets, any assets, irrespective of risk or return? The central banks have created a new class of investor, the ‘zombie investor’ that will buy any asset.
Bottom line: Despite the perception that this policy stance can run indefinitely, it is an illusion. At some point, there will be a collective moment of clarity, an understanding that asset prices have diverged from fundamentals. The fact that risk assets are rallying alongside safe-haven assets, should say something about the dysfunction already in the system.
Pivoting away from the news flow surrounding the Tory leadership contest, there is little data out to impact the Pound this week.
While the geopolitical scene appears to be softening as markets open, there is some important US data out which has the potential to steal the spotlight.
Last week’s EUR rally was driven primarily by USD selling, but having reached the trade-weighted 200-day moving average—a four-month high—economic data will be increasingly under the microscope.