Search
  • Credence Capital IIM Lucknow

Why Central Banks Matter

An essay.


Financial markets nowadays seem to be driven by (expected) central bank action more than anything else. Barring major events such as the EU referendum in the UK, the focus tends to be on the data that would influence the Federal Reserve to raise interest rates, and the monetary policy (rates together with quantitative easing) of other major central banks such as the European Central Bank and the Bank of Japan. This essay tries to bring together the reasons why, and how, central banks move the markets so much.


The How of it


It is well known that a central bank’s monetary policy influences the interest rates in the economy it has jurisdiction over. In addition to interest rate itself, the central bank oftentimes controls the quantum of money in circulation. Its actions are meant to reach a certain targeted inflation rate in the economy, while maintaining stable GDP growth for which unemployment rate is sometimes used as a proxy.


The Federal Reserve (the Fed), USA’s central bank, influences what is called the “fed funds rate”. Each bank is required to maintain a certain reserve at the central bank, to be used in times of liquidity crunch. However, on a daily basis, banks keep borrowing from one another to meet their liquidity or reserve requirements, before approaching the central bank for more money. When banks in the US borrow from one another against the security of their reserves held with the Fed, they do so at a rate called the “fed funds rate”. The weighted average of these fed funds rates is called “fed funds effective rate”. The Fed tries to keep this effective rate within a certain range or at an absolute value. This range/value is called “fed funds target rate”. The way the Federal Reserve brings the fed funds effective rate close to its target is by influencing the quantum of liquidity in the system, through a process called open market operations (OMOs). If the Fed wants to reduce the effective fed funds rate, it will pump in more money in the system, thereby reducing the need for banks to borrow from one another, and consequently reducing the interest rate at which they do such borrowing. This also forms the basis for further bank lending.


Another action in news is Quantitative Easing (QE). The above action of OMOs and rate setting has two limitations: prevailing interest rate may already be close to zero or some such lower bound; and the rate so influenced is typically short-term in nature. QE is the process by which the central bank directly buys or sells longer dated bonds of a certain “quantity” (hence Quantitative Easing), which helps inject or draw money into or from the economy, and influence interest rates of the longer term.

Closer home, the Reserve Bank of India also sets a rate but not the inter-bank borrowing rate like the Fed. It fixes the repo rate which is the rate at which commercial banks can borrow from the RBI against a security (such as bonds). The European Central Bank, on the other hand, sets the “depo rate” which is the interest the ECB pays banks for deposits held by it on their excess balances. Other central banks similarly influence interest rates in the economy by targeting some such key interest rate, or by engaging in QE.


But why does it matter so much?


There are many good reasons why central banks, especially in these times of low growth and returns propelled by easy money, are so closely watched for every word they utter. The financial markets seem to react to every data point and development that could potentially lead to a central bank action or make it more or less likely. This probably also reflects a dearth of other drivers in the markets. Let us explore some important reasons why all this technical stuff has come to influence lives so much.


1. Rates make the base: Trillions of dollars’ worth of financial products are based on interest rates. Right from the loans we as consumers take, to the cost of capital of large companies, all depend on the prevailing interest rate in the economy. In countries like India where the interest rates are already at 6-7%, perhaps small changes in the rate do not have a great deal of immediate impact. But in countries with zero or even negative rates, a 25 basis point move effectively entirely changes the cash flows on loans and throws the cost of capital calculations awry. Looking beyond just loans, more complex stuff such as securitized products, bond issuances, and speculation in the rates market are directly and immediately affected by central bank policy. With central banks themselves closely tracking high frequency data (non-farm payrolls, monthly inflation numbers, quarterly growth numbers) more than ever, markets are also forced to take into account all such developments seriously.


2. Money is cheap, and everywhere: We live in a world flooded with liquidity and cheap money. In certain countries such as Switzerland, Sweden etc, you’re literally paid to borrow money. Now there are always the investors who want to manage money either for themselves or their wealthy clients or pension funds etc, and keep looking for high yielding assets. With the interest rate market affording record low yields, the money spills over to equities, especially in stable emerging market economies, and alternative asset classes such as real estate. They call it “bubble”, meaning something priced way beyond what it is actually worth, simply because there is too much money chasing it. India itself has seen an average monthly flow of INR 6,600 crore from Foreign Portfolio Investors in the equity markets since 2010, and INR 3,500 crore in the debt market. Bubble or no bubble, the excess liquidity generated due to central bank bond buying program (QE) and low interest rates, has definitely made global markets very vulnerable to shifts in these flows (interestingly, Bank of Japan already holds a third of Japanese Government bonds). And these flows are sure to get affected when the central banks even hint at tapering off the liquidity that they have been pumping.


3. Panicking pensioners, rejoicing managers: Thanks to central bank bond buying, it is believed that in many cases the yield on fixed income instruments are artificially depressed. Now there are, at one end of the spectrum, pension fund and insurance fund managers for whom this suppression in yields is a problem. Many such funds are mandated to invest at least a portion of their corpus in bonds and now with bonds yielding nothing, they face prospects of not being able to meet their future obligations when retirees are due to be paid. At the other end of the spectrum are corporate finance managers who gleefully accept this situation as a short term funding opportunity. Companies are raising more debt than ever (for example, Apple went from zero debt until 2012 to over USD 75 billion now. A company sitting on cash pile of about USD 240 billion scarcely needs to raise debt. But it is doing so only to reduce its overall cost of capital, because debt is so cheap). But when interest rates begin to rise, their smart strategies could come to naught. And in the middle are money managers of hedge funds et al who are experiencing the peculiar situation of fixed income securities behaving like equity (in the form of capital appreciation) while Equity securities behaving like fixed income (steady nominal gains acting as regular income). Lower yields lead to higher bond prices and those who have held on to bonds are finding their capital to have appreciated, and those that held equity are finding their stocks to be going up at a steady but slow pace, almost like holding a bond. For all three types of investors, what the central bank does is of immense importance now given the skewness in risk-return profile of various asset classes.

4. No bond business? Forex will still impact you: Foreign exchange markets react instantaneously to any data point, even if it may not change expected central bank action. Immediate USD strengthening occurs with data pointing to strengthening of US economy, and emerging market currencies generally weaken with expectation of hastened and/or larger outflows of money. With growing internationalisation of businesses and most major currencies now trading in the market, currency movement becomes a source of worry for many firms. When expectations from central banks on rates and QE change, currencies can witness wild swings in value. This again makes it imperative for managers whose businesses are FX-sensitive to keep an eye on the direction that monetary policy could take.


5. Experts of the last resort: Central banks are an important source of expert opinion on the likely direction of the economy. The minutes of the meetings, press conferences, and policy reports help develop sentiment and give direction to expectations on inflation, growth and the like.


Central bank activity, especially one that is data dependent like it is today, is a strong influencer on all asset classes, particularly rates, FX, and equities. To an extent, perhaps, news commentary may be over-doing the role of central bank hints in the movement of asset prices. However, it may be difficult to dispute that with few other drivers of global growth and some even questioning the ability of central banks to do more to stimulate growth, the sensitivity of assets to policy action is likely to remain high.

- Umang Khetan

5 views

Recent Posts

See All

Why we got it all so wrong

Read anywhere, and both Brexit and Trump’s victory come as “stunning upsets”, “shocking”, and “unexpected”. Financial markets moved massively when the outcomes became clear, only to revert to pre-resu

SIGN UP AND STAY UPDATED!
  • Grey Facebook Icon
  • Grey Twitter Icon
  • Grey LinkedIn Icon

© 2020 Credence Capital