The increase in market instability might come as no surprise?

29 Oct 2018

The European Central Bank reiterated its intention to stop using large liquidity injections to support economic activity and asset prices. The change in this “global factor” is translating into a volatility “regime change” in markets, requires an evolution in investment strategies, and calls for compensating pro-growth policy measures on the part of many individual countries, economic experts say.

The European Central Bank’s October 25 announcement that its governing council still intends to stop large-scale asset purchases, known as quantitative easing or QE, at the end of the year occurred in the context of what central bankers acknowledge is an increasing list of threats to their economies. At a news conference after the central bank’s policy meeting, ECB President Mario Draghi said the risks include an uncertain trade regime, pressures in emerging markets, politics and the budgetary confrontation between Italy and the European Union. And by stating that the “ECB mandate does not involve financing government’s deficit,” Draghi emphasized the implicit message that neither governments nor markets can continue to rely on regular, large and predictable liquidity injections to offset their own problems.

The increase in market instability might come as no surprise. It was clear from early in this (now-ending gradually) exceptional monetary-policy phase that central banks’ “unconventional policies” were aimed at repressing volatility as a means of promoting economic activity. Also, central banks have been consistent and clear about their intentions to exit this phase as economic conditions allow, economists say.

The resulting journey away from the prolonged implementation of unconventional policies inherently involves more financial and economic volatility. This is especially true given how much market participants have downplayed liquidity risk in certain segments and how many governments have been slow in implementing pro-growth structural reforms. What the destination will look like remains an open question, economic experts think. The outcome essentially depends on the orderliness and comprehensiveness of the handoff to better economic and corporate fundamentals, as well as the reset of market technical, they say.

The message to governments, corporates and market participants is: Central banks are dead serious about getting out of the business of suppressing volatility, and the process could be approaching critical mass. Much like what happens to you when you take off those fancy noise cancellation headphones in midflight on a plane and notice all sorts of noises around the cabin, markets and economies are becoming more sensitive as QE and guidance on low rates decay.

Economic actors and market participants need to get ready for greater environmental instability as monetary policy transitions away from unusual and experimental measures to historically more recognizable ones. This change has the potential to place both the global economy and markets on a more solid fundamentally-based foundation over the longer-term. But it also requires timely adaptations in both or the possibility of the better could give way to the worse.

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