Stock-market investors, especially the very bullish ones who have been proven right and have been richly rewarded in recent years, are in the midst of a gradual transition in their operating regime.
Their environment is moving away from comfortable reliance on central banks that are able and willing to support asset prices and towards a White House that appears less constrained by Congress in pursuing pro-growth policies, given the Republican majorities in both houses of Congress. Two events this week will attest to the speed of this transition, though without shedding much light on its potential effectiveness.
For much of the period since the 2008 global financial crisis, markets have been able to rely on central banks to repress financial volatility and boost asset prices—not as an end in itself for policymakers, but as a conduit to higher growth and faster balance-sheet repair. Over the last few weeks, however, the Federal Reserve —using the public reasoning of higher global growth and inflation—seems set to resume gradually, lifting its foot off the accelerator. This includes a skilful and carefully orchestrated management of market expectations that, with the assist of solid data, has tripled the implied probability of a March Fed hike to almost 100% in just a few days; and without causing major disruptions to markets.
The Fed is not the only systemically important central bank that may be in transition mode, particularly given the growing awareness of the potential costs and risks of remaining too loose for too long. For its part, the European Central Bank (ECB) has come under pressure to consider reducing its balance-sheet support for markets as a prelude to abandoning negative policy rates. Meanwhile, the governor of the Bank of Japan has publicly questioned the continued effectiveness of a pedal-to-the-metal approach to unconventional monetary policy.
This change has not been of major concern to markets because of what Jonathan Ferro, the co-anchor of Bloomberg Television’s US morning show, has referred to as the “presidential put”—that is, the markets’ willingness to embrace prospects for pro-growth policies under the new Trump administration. This is due to two factors: repeated comments by President Donald Trump signalling his intention to pursue the trifecta of pro-growth measures involving deregulation, infrastructure and tax reform; and the reduced threat of paralysing political gridlock on Capitol Hill.
In sum, the major question facing stock markets is less about the nature of the regime shift and more about its timing and effectiveness.
The ECB policy meeting on Thursday and Friday’s job report will have some influence on the speed of this transition.
Consensus expectations suggest that the ECB’s governing council will acknowledge the improved economic situation but refrain from any policy changes, especially given the proximity of the French election and the upcoming scheduled trigger of Brexit’s Article 50 by Prime Minister Theresa May’s government in the UK. The market regime transition would be accelerated, however, if the central bank also took this opportunity to change its forward guidance—away from signalling continued loose and, effectively, open-ended balance-sheet support to suggestions of a gradual taper over time.
On Friday, the US jobs report for February is likely to provide the final data point that the Fed needs to hike interest rates in its policy meeting next week. Indeed, only truly horrific job creation and wage data would dissuade the central bank at this point.
And, alternatively, were the data to be extra strong—involving, for example, job creation of more than 200,000, a significant boost in wage growth and a stagnant labour participation rate that suggests limited slack remaining in the labour market—the Fed could even signal next week that the balance of risk to its baseline of three rate hikes this year has shifted to the upside. And this would be part of a change from data dependency to a more strategic approach to monetary policy.
When it comes to effectiveness, markets have yet to internalize the multiple dimensions associated with the simple fact that this is a different type of “put.”
On the positive side of the ledger, for example, transitioning from over-reliance on central banks to a broader policy response has the potential to generate higher and more inclusive growth, as well as strengthen the underpinnings of genuine financial stability. Both of these would help validate existing asset prices and even push them higher over time in a sustainable fashion.
On the negative side, however, the new policy construct is less autonomous when it comes to implementation. Unlike the Fed, which can pursue measures without congressional approval (though that offers a significantly narrower policy set), the President needs congressional approval for a lot of what he has suggested for promoting growth. And such approval is subject to influences that go beyond the merit of the measures themselves.
As an illustration, there is some concern that the administration’s taking on healthcare ahead of tax reform means the implementation of an important item of the pro-growth agenda could be delayed by political divisions over the effort to repeal and replace Obamacare.
The “central bank put” was extremely supportive of asset prices for several years. For the “presidential put” to be similarly beneficial, good policymaking by the Trump administration would not prove sufficient unless it is accompanied by sound economic governance by Congress. Bloomberg
Mohamed A. El-Erian is a Bloomberg View columnist.