Are You Obsessed with Central Banks? BlackRock Thinks So

Central bank action has manipulated markets – is it time to take a step back and take stock?

(May 30, 2013) — Investor interest in central bank action has turned into obsession in recent years, according to BlackRock’s Global Chief Investment Strategist, Russ Koesterich, and the markets are dancing to their tune.

The main reason? Central banks’ vice-like grip on interest rates and asset purchase programmes, including quantitative easing, that have created a false environment and uncertain, wary market participants.  

“Investors are now parsing any central bank utterance for the slightest change in language or tone,” says the BlackRock man. “For several years now, ultra-low interest rates and expanding central bank balance sheets have been nudging investors toward higher risk assets such as stocks and high yield bonds. In this type of environment, any potential change in central bank conditions could have the potential to create a different investment environment.”

Koesterich may have a point. This week, trading volumes of US treasuries and UK gilt futures have gone through the roof to hit highs not seen since before the financial crisis. The catalyst was Federal Reserve Chairman Ben Bernanke implying the end of QE may well be in sight and everyone rushing to check and alter positions.

Consider market movements in Japan over the past few months. Once a nation in the doldrums, the arrival of “Abenomics” (named after the Prime Minister) fired the engines of the world’s third largest economy and Japanese equities were the new top bet in town. Consider then what has happened over the last seven days.

“Many of the market headlines focused on the sharp and sudden correction in Japan, but in our view the real cause for the return to volatility was increased investor anxiety over central bank policy,” says Koesterich.

Is this obsession going to dissipate any time soon? Unlikely, says Koesterich, but investors can help themselves by being aware of this trance-like state of markets.

“First, as we arguably get closer to some modest changes in Fed policy, investors should expect to see increased levels of volatility. For the past five years, investors have grown accustomed to monetary policy going in only one direction: toward more easing. While we expect the Federal Reserve’s shift away from its current stance to be slow and gradual, investors will need to become acclimated to the reality that policy can also tighten. We are hardly suggesting that investors should abandon stocks, but we would argue that investors should prepare themselves for more bumps along the way,” says BlackRock’s chief investment strategist.

“Additionally, we would suggest that investors be cautious about those areas of the financial markets where valuations have become more distorted by unusual monetary conditions. For US stocks, this would include small caps and even some dividend payers, especially ones like the utilities sector.”

In fixed income, all eyes are on US Treasuries, which have seen significant highs over the past couple of weeks. Koesterich says this is likely to continue, although credit and loans will still do well in the short-to-medium term.

If it is an obsession, it’s at least an understandable one, but it might pay dividends to be a little more self-aware than the rest.