It's been happening for some time now, and it's relentless. There's a collective myopia permeating markets which is driving prices in a flawed direction. And what's more, there are no signs that it's coming to an end any time soon.
Perhaps the best starting point is monetary policy, which has been driving asset prices higher; this is no revelation. As central banks—the Fed the largest of them all—decrease interest rates, the effect is to reduce the cost of borrowing and the benefit of savings, simultaneously driving funding to riskier assets. Quantitative easing works in a slightly different way but produces a similar outcome—lower interest rates and higher asset prices.
The flip side of that coin is that monetary policy should be based on fundamental economic data. If the economy is weaker, the central bank will ease monetary policy to stimulate the economy and vice versa. As part of that decision, in determining the correct policy tools, the central bank will need to assess the effectiveness of the tool and its fit to the economic malady. To use a crude analogy, they need to use a screwdriver for a screw and a hammer for a nail.
Taken together, working from cause to effect, the economic conditions warrant action, which leads to a policy action, which leads to asset price effects. In that way, there should be a direct connection between economic conditions and asset prices. Weakening economic conditions decrease prices, while policy easing helps to support them.
In the current market, the first part of that dynamic is absent. Economic conditions are weakening, but no discount to assets is being made. The market is only looking at the second part of the dynamic: central banks are easing policy, which will continue to result in price increases. Of course, the problem with this view is the presumption that central banks will continue to lower policy ad infinitum. By all accounts, this is wrong too. Last week, the outgoing European Central Bank (ECB) President, Mario Draghi, expressed concerns about continuous easing without sufficient economic rationale. It might not only be markets which are set to 'automatic'—perhaps central banks have been too prescriptive in the absence of fiscal policy support. Some policymakers are beginning to question the efficacy and appropriateness of further monetary policy action, which should make markets nervous.
Bottom line: For some time, central banks have talked in vague terms about the decreasing benefit of monetary policy but won't be more specific for fear of appearing hamstrung. Some market participants and central bankers have become more vocal in their criticism of blind policy easing. When policy rates are at zero, or below, the link between lower rates and economic growth is not only hard to define, it borders on fantastical. The market's knee-jerk expectation of perpetual monetary easing is harmful in that context because, at some point, the gap between market expectation and central bank policy action will reduce to zero. Ironically, the policy recommendation at that stage is likely to be zero as well.
The week ahead
Growing fears over a disorderly Brexit are expected to dominate price action for Sterling in the coming week. The Bank of England (BoE) rate decision and follow-up press conference also has the potential to produce some volatility in an otherwise data-light calendar.
It'll be a bumper week for the Dollar with multiple data releases set to drive the currency. Trade negotiators will also travel to Shanghai for renewed talks with their Chinese counterparts.
As there's only a handful of minor Eurozone data releases, it could be a quiet week for the common currency. The European Central Bank's warning that the economic outlook is diminishing could be backed up by the preliminary Gross Domestic Product (GDP) reading.