Central Banks' Weakening Power

Last week's ECB flip in equities points to a deepening trend...

MOST conspiracy theories in the market don't stand up to scrutiny, writes Greg Canavan in The Daily Reckoning Australia.

That is, they are just plain wrong. They are a way for people who have got it wrong to justify their error.

But recent market action has me wondering just what is going on...

It's well known that central banks drive markets these days. Policy announcements about what they are (or aren't) going to do dictate the movement of trillions of Dollars of speculative capital.

Sometimes it works out as planned, sometimes it doesn't.

When the Bank of Japan (BOJ) announced negative interest rates at the end of January, it didn't go according to plan. Markets rallied briefly, but then began selling off. It seemed the Pavlovian response to a central bank announcement (that is, for the market to rally) no longer worked.

Then we had the European Central Bank (ECB) meeting last Thursday. Once again, boss Mario Draghi threw the kitchen sink in...and the response was negative. The market didn't like it. It seemed as though punters had positioned for more...and were disappointed.

The market rarely gets these things wrong. It is a forward-looking beast. Yet the next day, European investors decided they were in error. They reversed the judgment made from the day before, deciding stocks were indeed worth buying...and that the ECB's policy was a good one.

This seems outright fishy to me. My guess is that the ECB followed their monetary policy announcement up with a forceful chat with some major investment banks. The next day stocks soared as market players removed 'risk hedges' and bought up stocks.

To understand this dynamic, it is important to recognise the nature of global markets these days. The stocks that you're used to buying and selling are only part of the story – a small part.

Global markets are now absolutely soaked with derivative products. That is, financial products that derive their value from interest rates, currencies, stocks, bonds or indices.

This derivative marketplace means it is cheap and easy for global capital to take leveraged positions and/or to hedge (protect against, or profit from, falling markets).

Global central bank action since 2008 has simply added fuel to this derivative fire. As central banks pump more cash into the system (think of it as demand for financial products), Wall Street creates the supply to meet it.

And the supply is mostly in the derivatives space. This exacerbates bullish and bearish financial conditions, because market players can easily take advantage of both through the use of derivatives.

That's why central banks find it increasingly hard to control the bullish narrative. As interest rates (at least in Europe and Japan) head into negative territory, banks find it harder to generate profits from their traditional lending activities. This is bearish for markets in general because if banks are struggling, the market tends to struggle too.

So the ECB had to really strong-arm the markets into believing that their policies are good for stocks. This approach works in the short term, but in the long term you can't push back the tide.

How long is short term though? How long can you expect this risk on rally to last?

Let's have a look at the largest stock market in the world, the S&P500, to see if we can find some clues...

You can see the August 2015 panic sell-off quite clearly. This was when fears of Chinese currency devaluation first surfaced. It was related to the Fed's first expected interest rate rise.

The market then recovered as the Fed backtracked. But it didn't reach a new high. This was the first warning sign that the market had topped out for the time being.

Then the Fed raised rates in December. The market sold off again, hitting new lows in January and February this year. Since mid-2015, the market has made a 'lower high' and 'lower low'. This tells you the trend is down.

If this trend continues, you'll soon see another 'lower high', and the market will set its sights on the lows from earlier this year. Global capital will shift into bearish mode, pushing prices quickly down to this level.

But that hasn't happened yet. Markets are still rallying. The question is how far this current rally can take us. Much will depend on the Federal Reserve. The BOJ and the ECB have done their bit for now.

The Fed meets this week to decide on its next interest rate move. Unlike the other major central banks (and China) the Fed is on a tightening path. This makes for an interesting dynamic.

While the Fed won't do anything this week, it will probably prepare the markets for another rise soon. From Reuters:

"The Federal Reserve won't raise interest rates this week, but will likely make clear that as long as US inflation and jobs continue to strengthen, economic weakness overseas won't stop rates from rising fairly soon.

"That will be a big change from the last time the Fed met, when uncertainty over the impact of slower growth in China and Europe drove policymakers to signal it would stay on hold until it could make a better call on the outlook."

Easy money in Japan, Europe and China versus a tightening of the monetary noose in the US. It will make for an interesting next few weeks. Keep an eye on the S&P500...see whether it makes a 'lower high'. That will give you a clue about where the market is heading next.