When watching a horror movie, the scariest part is when a shock is impending. It can occur at any minute. Anxiety runs high.
I think the same holds true for central bank intervention. Investors may be nervous about being under-invested knowing that central banks could intervene at any moment to push prices higher. However, once the central banks reveal their next action, the risk of the unknown (what/when will the next action be) is removed. Then investors can do the math. If investors conclude that the intervention was insufficient, that can be a problem for the market.
What if central banks try to circumvent this risk by going “all-in” (in poker terms)?
Over the past two weeks, my assessment is that the European Central Bank (ECB) and US Federal Reserve have essentially gone “all in.” The ECB announced on September 6 a program to buy unlimited sovereign bonds to address “severe distortions” in the market. This past week, the Fed announced that they would buy bonds and securities at a rate of $85 billion per month through the end of the year and $40 billion per month thereafter with no limit on timing. Further, they stated: “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”
The risk to ‘unlimited’ stimulus is that there is no improvement as a result. Maybe lowering interest rates further won’t change the perception (or perhaps fact) that some assets (homes, factories, etc) have limited value. In this case, I would expect more defaults to be forthcoming. Or perhaps economic problems continue unaffected by stimulus measures or asset prices. Such a progression of events might support the belief that central banks are ‘pushing on a string’ and are therefore ineffective.
Central banks can always increase the size of their stimulus. However, if “unlimited” purchases did not work the first time, adding money is simply an extension of unlimited, which is the status quo which is proving ineffective. If “all in” was insufficient, what next?
To clarify, this risk is not my base case expectation. There is a reason for the saying, “Don’t fight the fed.” Bernanke continues to state that one of his goals is see the stock market go higher. It is because of this that there is discussion of the “Bernanke put,” effectively a belief that investors should be comfortable buying stocks because the Fed will intervene if the market goes down. All things being equal, the recent central bank actions are supportive of higher stock prices. Whatever long investment holdings I had before, I like them a little more now.
However, risk has not been eliminated, and I think that a new risk has emerged: against the backdrop of “unlimited” stimulus, more economic stresses or market declines could cause investors to lose faith in the “Bernanke put.” Confidence could erode quickly such that further central bank action might not help. This seems to be a low-probability scenario at this point, but it is a scenario with big downside potential and therefore must be kept in mind.