The global financial markets’ slide on Thursday was a stark reminder of the fact that investors remain addicted to cheap money from central banks. It only took U.S. Federal Reserve Chairman Ben Bernanke informing Congress that the purchases of Treasuries and mortgage backed securities could be reduced in the “next few meetings” to spark a rush to exit, particularly in Japan and in most European stock markets.
Investors seem to admit that the recent rally has very little to do with economic fundamentals and very much to do with monetary overstimulation. Given the recent gains—for example, the Japanese stock market went up 70% in just a few months—a correction is not a bad thing, per se. However, it is significant that perfectly sensitive comments by Bernanke, in which he was neither particularly hawkish nor dovish, had such an effect.
Notably, it was primarily the financial markets of weaker economies, i.e. Japan and Europe, which suffered the most. While it is true that the monetary drug is making everybody dream, financial addicts still seem to remember that some economies are far from recovering and need to be handled with care. Japan is a particular case as a result of the veritable monetary orgy that is taking place over there. Will monetary overstimulation defeat deflation? Will it put the Japanese economy back on track, or create the conditions for chaos and inflation? Intended and unintended consequences go hand in hand, and it will take time before clearer patterns emerge in the Japanese economy. Hence, mood swings in the Far East are bound to stay with us for a while. Fasten your seat belts for a notable increase in volatility.
Europe is a different case. The fact that the continent’s economy is not doing well should not come as a surprise. Recent data from the continent is very soft and even the German economy is stagnating. The recovery that should come in the second half of the year certainly does not feel within grasp. But if it is true that Japanese investors have turned to European stocks and bonds in a frantic search for yield outside of their own country, Europe is and will continue to be exposed to more frequent shocks. Indeed, the flows of capital could dry up rather quickly.
It is true that hot money seems to have pushed down yields on sovereign bonds of weaker countries. However, that in itself does very little to restore a healthy flow of credit to small and medium sized companies in the periphery of Europe. SME’s have little access to capital markets and will continue to do so until it becomes easier for them to securitize their bank loans. For now, the actions taking place on financial markets are completely bypassing large sections of the real economy—certainly that part of the real economy that should create jobs.
Global investors will now take a second look at Bernanke’s statement and conclude that the glass is still more than half full. Markets flirted with a correction, but I fear that they will soon resume their wild ride. After all, the softer the economic data, the more likely current monetary policies will remain in place. Bernanke was very clear on that. How long this divergence between markets and the real economy can last is anybody’s guess. The last few days proved that even minor tremors have consequences, and volatility can quickly stage a dramatic comeback. A significant correction will take place at some point in the not so distant future. For global investors, Thursday represented a rehearsal. Let’s just hope that by crunch time, the real economy in the U.S., and more importantly in Europe, is strong enough to absorb the shock.