Beware of Central Banks Bearing Gifts

 | Jun 16, 2017 | 8:00 AM EDT
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When thinking about who is behind the extraordinary jump in investment risk-taking, your buttoned-up, serious-talking central banker is not the first figure who comes to mind. After all, central bankers keep warning about the need to be prudent.

But look beyond their words, and a different picture emerges.

While the Fed raised its interest rate as expected earlier this week and provided some information about winding down its asset purchases, the Bank of England maintained its interest rate at a record low 0.25% on June 15.

Many analysts were surprised that three members of the Monetary Policy Committee voted to raise interest rates. The pound even strengthened a bit in response.

This shows how much market perception has been distorted by central banks' actions since the 2007-09 financial crisis. The vote by the three hawkish MPC members should not be surprising. The thing that is surprising is that the Bank of England did not raise interest rates. Inflation came in at 2.9% in May, compared with the bank's target of 2%. At this point, the bank is ignoring its own mandate.

Inflation has exceeded the central bank's expectations. Last month, the bank said price rises would peak at "a little below 3%" in the fourth quarter of the year, and that trying to fight the effects of the weak currency on prices would cost too much in terms of unemployment and economic growth. But its own mandate is to keep inflation around 2%.

I wrote last month that the Bank of England risks its independence and the pound by not defending the inflation target. On a wider point, major central banks around the world have been veering off the relatively narrow course that had been set in their mandates. This is changing the investment environment, making it way riskier than it would be otherwise.

"The central banks around the world, they no longer view their mandate as only balancing inflation and unemployment. They view their job as preventing asset prices from going down a lot. This was never a job that central banks were supposed to be doing," Gershon Distenfeld, director of credit at AllianceBernstein, told Real Money in an interview earlier this week.

Others in the markets share this opinion. Central banks now are dominating market trading not only with the size of their balance sheets and the share they have of debt instruments outstanding (around a quarter in the U.K., for instance), but also by the increasingly important role they play in investment decisions.

If, before central banks became so important, an investor could hope to buy a bond by looking at characteristics such as its maturity, coupon, covenants and the fundamentals of the company that issued it, the same investor now probably would look at these only after analyzing what the central bank is likely to do in the market where the bond is launched.

If the bond is launched at a "good" time -- i.e., when the central bank is buying corporate bonds -- its yield, which moves inversely to price, will be much lower than if it is issued at a time when the central bank is winding down its asset purchases. Thus, the investment decision depends on the actions of the central bank at least as much as on the fundamentals of the company.

Besides pushing down yields to levels where they forced investors into much riskier assets than perhaps they would like -- think sub-6% yields on junk bonds -- central banks also are encouraging moral hazard. Even if not explicitly telling investors "I've got your back," a central bank that comes into the market and hoovers up securities makes it quite clear it will not let that market go down sharply.

And this is the main problem: Markets always will find a way to correct, even if takes them a while to figure out how. Perhaps this is why the Fed, in its statement on June 14, essentially normalized asset purchases, changing their status from emergency measures to everyday ones. It knows that a central bank, once it steps into a market, can never get out. Not without crashing that market, anyway.

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