European Central Bankers Rattle the Markets

Do you remember the Taper Tantrum? Europe had its own version this week.

Back in 2013, Fed Chairman Ben Bernanke caused a panic when he casually stated in a congressional hearing that at some point the Fed would stop its quantitative easing and reduce the assets on its balance sheet. Many investors thought the change was imminent and adjusted their portfolios.

Interest rates rose sharply in response and caused steep declines in interest-rate-sensitive investments. After a few weeks, investors realized they overreacted, and most of the market changes began to reverse.

This week, something similar happened in Europe. First, European Central Bank (ECB) President Mario Draghi said in a speech Tuesday that the recent strength in the European economy left the ECB room to reduce its extraordinary measures without tightening monetary policy.

Rather than taking it for the sensible, cautious statement it was, the markets reacted as if he was hinting that the ECB was getting ready to reverse its policies. The euro and bond yields both rose sharply. Stocks declined a bit.

The ECB quickly put out statements that Draghi’s comment was consistent with current policies and the market reactions were hard to understand. The markets quickly reversed.

Then, on Wednesday, Mark Carney of the Bank of England (BOE) said the BOE might begin raising interest rates soon. The markets reacted the same way they did after Draghi’s speech. The euro and interest rates rose.

The series of events brings home two points.

One point is that the era of extraordinary monetary policy by central banks is nearing its end. At least the central bankers hope it is. In the United States, the Federal Reserve discontinued its quantitative easing several years ago and has been slowly raising interest rates. In Europe, quantitative easing continues, but it is scheduled to be suspended at the end of 2017 if the economy is strong enough.

The central bankers all say they are flexible. But they also say they want to return to normal policies and interest rates when their economies allow.

The second point is that the markets are very sensitive to changes. Many assets are priced on the assumption that low interest rates and low volatility will continue. Investors believe central bankers have been supporting markets, that the markets need that support and that it will continue. Small changes or even hints of small changes cause investors to reevaluate.

We saw that sensitivity in the United States in 2013 and see it now in Europe.

If central banks tighten more than the investors expect, markets could decline significantly. Central bankers are likely to pay attention to the recent events and tighten policy less quickly than they’d like. But fears of tighter monetary policy cause market interest rates to rise, and that in itself is a tightening.

Investors need to realize that the change in monetary policy is underway. You should expect higher volatility and protect yourself from higher interest rates and the potential for central bankers to make mistakes.

The Data

Residential housing continues to deliver mixed data.

New home sales rose 2.9% for the month, and last month’s number was revised sharply higher. Also, selling prices increased 11.5% for the month, giving a 12-month price increase of 16.8%. Over 12-months, sales increased 8.9%.

But pending home sales declined 0.8%, and last month’s decrease was further downgraded to a 1.7% decline. This is the third consecutive month of declines.

Housing prices were a little weaker in April, according to the S&P CoreLogic Case-Shiller Home Price Index. Prices rose only 0.3%. And March’s 0.9% increase was revised down to 0.5%. The 12-month price increase now is 5.7%.

Manufacturing also turned in some mixed data.

The surveys by the Fed regional banks continue to be positive. The Dallas Fed Manufacturing Survey was 12.3, down from 23.3. The high numbers of the last few months weren’t sustainable, so the decline wasn’t a big surprise. The Richmond Fed Manufacturing Index shot up to 7 from 1. That’s the eighth consecutive month of expansion for that index.

But the hard numbers of Durable Goods Orders weren’t as positive. Declining aircraft orders caused the headline number to be negative 1.1%. After excluding transportation, orders rose only 0.1%. Even worse was that core capital goods orders declined 0.2% and are up only 5.0% over 12 months.

Other signs that the overall economy continues to lose momentum were in the midmonth PMI Composite Flash Index. The manufacturing declined to 53.0 from 53.9, and services declined to 53.0 from 54.0. Both measures indicate solid growth, but the rate of growth is slowing.

Slower growth hasn’t affected Consumer Confidence as measured by The Conference Board. It came in at 118.9, up from 117.9 last month. That’s below the high reported in the spring, but still is close to it.

For the first time since the technology stock bubble, the Consumer Confidence index posted seven consecutive readings above 110. Even so, few households report plans to buy homes or cars, and the strong confidence numbers haven’t translated into economic activity.

New unemployment claims rose only 2,000 to keep them near historic lows.

The third estimate of first-quarter gross domestic product (GDP) was another upward revision. GDP in the first quarter now is estimated to have grown at a 1.4% rate. That’s still weak growth but significantly above the first estimate. Consumer spending was revised higher, so it now ranks as the weakest spending quarter in four years instead of sinking to a seven-year low in the first and second estimates.

The Markets

The S&P 500 rose 0.23% for the week ended with Wednesday’s close. The Dow Jones Industrial Average added 0.21%. The Russell 2000 popped 1.92%. The All-Country World Index rose 0.66% and emerging market equities gained 0.78%.

Long-term treasuries fell 0.96%. Investment-grade bonds lost 0.20%.

However, Treasury Inflation-Protected Securities (TIPS) bucked the trend, gaining 0.18%. High-yield bonds rose, as well, 0.25%.

On the currency front, the U.S. dollar fell 1.51%.

Energy-based commodities finally stopped declining, rising 2.80%. Broader-based commodities returned 1.77% and gold gained 0.42%.

Bob’s News & Updates

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