A recession would threaten central banks’ independence

Central banks are again under the limelight. With Mark Carney’s departure as governor of the Bank of England next month, Boris Johnson could try to seize the opportunity to curtail the central bank’s independence.

This should not come as a surprise. Already, Johnson’s soulmate from across the ocean, Donald Trump, has been making noises about the Federal Reserve being too independent (or rather: insubordinate) for his liking.

So, if these two authoritarian populists go for central banks, what are their chances of bringing them under their rule?

In a previous article about how central banks enabled populism I warned then that they would be paying the price for this by surrendering their own independence.

If during the financial crisis of 2007-2009 the Federal Reserve and the Bank of England slashed interest rates and started printing money to halt the catastrophic falls in asset prices, later they allowed these “extraordinary” and “unorthodox” measures to become just ordinary monetary policy instruments.

They have managed during all this time to buoy markets everywhere, sending them to dizzying heights as rivers of money have been pouring into assets — debt assets in particular. Last week saw the biggest weekly inflow into bond funds ever, according to analysis by Bank of America Global Research.

Bond funds received $23.6 billion in the past week, with inflows into the asset class annualising almost $1.0 trillion in 2020. Equities too have reached a record: the highest-ever annualised flows of $443 billion, with $12.5 billion of that in the past week.

Capital flows into bonds and equities

The money printed by central banks ended up in areas linked to interest rates.

Looking at what investors are buying, investment grade corporate bonds saw their second-largest inflow ever, at $13.4 billion. High yield corporate debt, as well as emerging market bonds, have seen healthy inflows too.

Large technology companies have benefited from central banks’ largesse from the beginning, with a lot of the money created inflating these companies’ stock prices. They did well last week too, with $1.2 billion going into tech funds.

This just adds to the evidence that if central banks hoped that by printing money, they will spur growth, things haven’t worked out exactly as they planned.

“The irony is investors are doing exactly the opposite of what central banks expected to achieve in the first place,” Alberto Gallo, Head of Macro Strategies at Algebris Macro Credit Fund, pointed out in his latest research.

Assets directly linked to interest rates have been outperforming throughout the decade of quantitative easing and rate cuts, whereas assets whose performance depends on economic growth – such as small caps and value stocks – have been left behind.

This shows that investors are “hiding in assets which benefit from central bank liquidity while shunning what depends on growth.” Gallo wrote. “Even though liquidity-proxy assets are already expensive, money keeps pouring in.”

The question that every investor is asking is how long can this last. The coronavirus outbreak serves as a reminder that unpredictable events can scupper central banks’ efforts to inflate asset prices, as equity markets fell last month in response to the news flow about it.

Even though investors became more sanguine about the consequences of the virus, the effects on global growth will only now begin to be seen. Coupled with the impact of the US-China trade war and Brexit negotiations, they can cut quite deeply into the world economy.

If the US and indeed the world enters a serious recession, central bankers should be under no illusion about who populists like Trump and Johnson will blame for it. A grab for central banks’ independence is just a matter of time. A recession would offer the populists the perfect cover for it.