WESTPAC: There's a growing risk that central bank stimulus may disappoint

Photo by Ethan Miller/WireImage

It’s been a remarkable period for financial markets.

This time two week’s ago financial markets were in turmoil, spooked as the results of the UK Brexit referendum rolled in.

Risk assets were hammered, plummeting across the board. Safe havens such as gold, Japanese yen, US dollar and sovereign debt soared, reacting to heightened levels of uncertainty that the Brexit vote would bring, not only for the European Union but also the global economy as a whole.

That lasted for all of three days.

Out of the blue, uncertainty surrounding Brexit was replaced by certainty that central bank’s would come to the rescue. Risk assets soared, safe havens were dumped. Suddenly the world, at least to financial markets, was good again.

The prospect of unprecedented levels of monetary policy stimulus from the likes of the Bank of Japan European Central Bank, Bank of England and People’s Bank of China, along with greatly diminished prospects for near-term rate hikes from the US Federal Reserve, did as they have done so often in the post GFC years: Lift asset prices across the world.

It’s been a remarkable turnaround, and that’s saying something given what we’ve all seen in recent years.

While the risk assets continue to march higher on the belief that central bank support is a certainty, Martina Song, macro strategist at Westpac, believes that after such an aggressive move there is a risk that central bank actions may underwhelm investors, leading to a reversal of the current bullish trend.

“We are wary..(that the) story could change quite quickly,” says Song.

“Any Japanese government/BOJ stimulus could very well disappoint, especially given recent headlines on ‘helicopter money’ and perpetual bonds.

“In the UK, there had been some talk about the possibility of another referendum or a snap election. Parliament is also set to debate the EU referendum petition on a second referendum September 5. With new UK PM May filling her cabinet with three leave campaigners however, we could see Brexit risks reignite on a commitment to leave.”

Essentially, with unprecedented monetary and fiscal stimulus already priced in, and the threat of a UK Brexit still lingering, the risks now appear slanted to the downside, rather than upside.

It’s “baked in the cake”, to borrow a term often used in financial markets.

While Song believes that the current trend could easily reverse, she believes that risk appetite — even after the recent recovery — is not yet at extreme levels, suggesting to her that this “should provide some insulation for risk assets”.

Song points to the chart below, supplied by Westpac, to justify her call. It shows the bank’s global data surprise index, overlaid against its separate risk aversion index. While recent economic data has, on balance, beaten expectations, investor risk appetite is nowhere near extreme levels.

“Our global data surprise index is at unsustainable highs meaning most of the ‘good news’ is behind us,” says Richard Franulovich, Westpac’s New York based chief currency strategist. “Our risk appetite indicator remains considerably shy of the extreme levels that typically warn a local peak is nigh and has a has long way to run before it matches the stronger tone to the global data flow.”

Based on that assessment, while there is a risk of a reversal should central bank policy underwhelm, any disappointment is unlikely to provoke a severe selloff across risk assets.

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