Central Banks Still Hold the Keys

Weekly Commentary Overview

U.S. markets, both stocks and bonds, were appeased last week by soothing comments from the Federal Reserve.
Stocks experienced some violent swings, but managed to eke out modest gains for the week.
Bonds also rallied, with both short- and long-term rates retreating.
Price action in other markets reflected a similar phenomenon. Just as the Fed's words brought solace in the U.S., still accommodative central banks around the world are helping to keep markets buoyant.
The key takeaway is that market swings, both positive and negative, continue to be disproportionately driven by central banks.

Gentle Fed Appeases Markets

U.S. markets, both stocks and bonds, were cheered last week by soothing comments from the Federal Reserve (Fed). In all, the Dow Jones Industrial Average added 0.65% to close the week at 18,016, the S&P 500 Index advanced 0.76% to 2,110 and the tech-heavy Nasdaq Composite Index rose 1.30% to 5,117. Meanwhile, the yield on the 10-year Treasury fell from 2.40% to 2.26%, as its price correspondingly rose.

Price action in other markets reflected a similar phenomenon. Indeed, just as the Fed's words brought solace in the U.S., still accommodative central banks in Europe and around the world are helping to keep markets buoyant. For investors, the key takeaway is that we’re still in a world where market swings, both positive and negative, are being disproportionately driven by central banks.

Volatile Week Ends on the Upside

While U.S. stocks managed to eke out modest gains last week, it wasn't without some violent swings along the way. The gyrations could be partly attributed to mixed economic data. Most recently, industrial production came in well below estimates.

But investors were encouraged by the Fed’s comments on Wednesday. The central bankers' statement raised the assessment of both the broader economy and the labor market, and confirmed expectations for a rate hike later this year. However, investors were relieved that the Fed's forecasts suggest a shallower path of rate hikes next year and in 2017.

With fears over the Fed calmed, bonds rallied. Both long- and short-term rates retreated, sending the yield on the 10-year Treasury roughly 20 basis points (0.20%) below its June 10 peak. The moderation in rates allowed for a rebound in stocks, a trend supported by increasing flows into equity funds.

For better or worse, we're still in a world in which market returns are heavily influenced by what central banks are doing, saying and even thinking.

For Better or for Worse

Markets in Europe and China also showed their reliance on the behavior of central banks—but it remains clear that this can be either good or bad.

Last week saw European stocks struggle, as investor sentiment is increasingly driven by the tenuous situation in Greece. With a 1.5 billion euro payment to the International Monetary Fund due on June 30, and funds flowing out of the Greek banking system, the window for reaching a resolution is closing. Progress has been made on certain issues, but differences remain on Greek pension reform—a critical topic given that the pension system represents an astounding 16% of Greece's gross domestic product.

The European Central Bank (ECB) has stepped in to manage the risk of outflows from the Greek banking system. Last week the ECB raised the ceiling on its emergency liquidity assistance facility, the mechanism that is providing liquidity to Greek banks in the face of exiting deposits. But even this may not be enough. In the absence of a more comprehensive political settlement, there is a growing likelihood that the Greek government will need to resort to some form of capital controls, perhaps as early as this week.

That said, investors should not equate the imposition of capital controls with a Greek exit from the euro. We continue to expect that a solution, albeit a temporary one, will be found. In addition, by providing liquidity to the broader eurozone (in the form of its monthly bond-buying program), the ECB is helping to limit the scale and duration of any contagion related to events in Greece.

Finally, there is China, where last week equity markets entered correction territory. Exchanges in both Shanghai and Shenzhen were down roughly 13% on the week. While there was no single catalyst, the loss of momentum is mostly a reaction to a crackdown in margin lending and an expected surge in IPO supply.

This comes after a more than 130% year-over-year increase in equity market valuations, largely driven by liquidity and central bank actions. The upshot is that Chinese stocks are likely to continue their ascent only as long as the authorities are willing to provide significant monetary stimulus.

The key takeaway for investors is that even as the Fed starts to normalize U.S. rates later this year, markets will still be benefiting from historically low rates and aggressive monetary stimulus from most of the world's central banks. For better or worse, we're still in a world in which market returns are heavily influenced by what central banks are doing, saying and even thinking.