Monetary Easing Wells Running Dry?

As a former meteorology major, I found myself intrigued by how steadfast a drought can be. Case in point, the Southwest remains in a deep drought after several years without a good, prolonged rainfall weather set-up. There was even a rumor or two about some water wells running dry in the Northeast as western New York is experiencing a pretty notable drought at this point. It just so happens that the monetary easing wells across the world may be running dry, too: not for a lack of 'water', but a lack of confidence that pulling up more water will further benefit the global economy.

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A look back at the last month of trading across the Dow Jones Industrial Average shows how large Friday's drop in stocks was. The index shed just under 400 points on the day, closing down just over 2.1%. Other American equities didn't fare any better, with the Nasdaq dropping 2.55% and the S&P 500 closing down 2.45%.

Global bonds took a significant hit worldwide after Friday's apparent broad turning-of-the-tide in central banks, and yields continue to rise as I type this at roughly 2:00 AM on this Monday. European peripherals are looking a bit shaky, too:

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Italy's 3-year government bond yield has risen over 117% as of 0700 UTC Monday, but even as I type this sentence about a minute after that screenshot, the yield has jumped to 139% in the last day. Longer-term bonds are generally showing 2% to 10% gains, with bonds beyond 10 years hovering near 3%. 

Elsewhere, Ireland's 10-year government bond has jumped over 30%, Spain's 10-year and 30-year bonds are both up over 2% in the last day, with their 3-year bond up nearly 70% as of this typing at 0704 UTC. Emerging markets have been acknowledged as a substantial part of the bond rally, as the hunt for yield has bled from developed economies into these riskier, but profit-producing bonds. Now, as we see a global bond sell-off continuing on from Friday into this workweek, one can't help but entertain the thought of what the global economy will look like even a month from now if this kind of anxiety over potential central bank hawkishness persists.

Forgive me, I feel like a guest at a party who's been talking for far too long. Let me introduce how we got here. Back on Friday, global markets began to wake up and smell the reality that is the limits to central bank action. The last week or so has seen the European Central Bank, the Bank of Japan, and the Federal Reserve all display increased hawkish tones in their actions. From the ECB, we saw President Mario Draghi refrain from any further monetary easing. The Bank of Japan was found to be in a tough spot, with concerns that it is running out of debt to purchase as part of its monetary easing program. And, to put it all together, usually-dovish Boston Federal Reserve branch president Eric Rosengren indicated it is plausible that normalization in monetary policy is coming much sooner rather than later. Financial markets reacted quickly and in typical knee-jerk fashion.

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The CBOE's volatility index (VIX) jumped nearly five points on Friday, up about 40% on the day. Given how low volatility has been since July, some form of rebound in volatility was expected. I like to think of this aggressive monetary easing as the equivalent of feeding the financial markets Xanax, in that it calms the markets, makes everything feel all fine and dandy. But now that there's signs central banks may be backing off, it's quite a sobering reminder and a signal that the 'Xanax effect' in the markets isn't invincible.

Already on this Monday morning, Asian markets took a hint from the American markets on Friday and continued the sell-off. The Nikkei 225 fell by nearly 300 points (1.73%), while Hong Kong's Hang Seng index is currently down about 685 points, or 2.85%. Using stock futures, American and European markets will see the slide continue Monday, and further drops are definitely still on the table, especially if the Fed's Lockhart, a typically-dovish member, turns hawkish. 

The fact of the matter is we're in the ~eighth year of this economic expansion, one of our longest in history. Every peak is followed by a valley, and whether or not the valley is coming sooner rather than later, the reluctance of central banks to continue propping up financial markets may hinder any further expansion, should a halt to easing come to fruition. It's time to start seeing how much central banks are willing to conserve the 'water' in their monetary policy wells, because the well's starting to look a bit dry.

Andrew