Since the financial crisis, economic fundamentals have not been the primary driver of asset prices. Rather, central bank actions have driven financial asset valuations. By pushing rates to zero and even negative territory and massively expanding their balance sheets, global central banks successfully inflated equity prices, compressed credit spreads, and returned housing markets back to pre-crisis highs.

Fundamentals have not kept pace with the move. Economic growth remains stagnant, corporate profits are declining and consumers remain strained by low wage growth. Trickle-down economic theories have thus been largely disproven. This has created great strain on many societies and resulted in a swell of populism and resentment towards existing establishments.

Why haven’t economic fundamentals mattered? Primarily, because central banks convinced investors they don’t need to matter. They did this by aggressively acting at any sign of negative economic news. As a result, investors got conditioned to expecting the medicine before they even got sick. When your doctor is telling you the cure for any illness is in your cabinet, why even bother washing your hands?

As such, “don’t fight global central banks” has been the recent investment motto. Yet, there are increasing signs that developed market central banks may no longer have investors’ backs.

What Has Changed Amongst Central Banks?

In the United States, the Fed continues to find reasons not to normalize interest rates. While this has supported asset prices by delaying any imminent recession, it also comes with a darker revelation. The Fed has very little room to ease monetary policy if the economy were to head south. Despite Ben Bernanke’s praise of negative rates in his recent blog post, Janet Yellen has been very skeptical of their impact in past statements. Furthermore, while Chair Yellen has publicly claimed that the Fed could do more Quantitative Easing (QE) in a future recession, the willingness to actually do so seems limited.

In Japan, the Bank of Japan (BoJ) recently announced a cap on 10-year yields at 0%. While this policy seeks to transition from a fixed quantitative amount of asset buying (80 trillion yen of Japanese government bonds {JGB} per year) to defending a yield target, the true goal was to steepen out the yield curve to help the net interest margins (NIMs) of Japanese banks. Yet, the BoJ did not lower the deposit rate from -0.1%, which would have been a more direct way to steepen the curve. Going forward, if 10-year JGB yields were to rally to -0.30%, the only options for the BoJ to steepen the curve would be to sell 10-year JGBs (which would tighten monetary policy and likely strengthen the Yen, when the opposite is needed) or to take the deposit rate significantly more negative than -0.30%. By showing initial hesitation with regard to embracing negative deposit rates, it is unlikely markets will take kindly to them being forced to into such policies. Thus, the BoJ appears more hopeful and reactionary than assertive and in control.

In Europe, the European Central Bank did not officially announce a QE extension at its last meeting. While the market expects Mario Draghi to eventually lengthen the timeframe for asset purchases, cracks in the QE foundation are appearing. The reluctance to extend purchases either highlights a questioning of its efficacy or increased awareness around the negative side effects it has on bank profitability. European banks have not been able to recapitalize to the extent that American banks have. The combination of negative rates, flat curves with reduced NIMs, increased regulatory burdens, stricter capital ratios, a tepid economy, and challenging financial markets have all hampered European bank profitability. When banks are struggling to survive, they decrease the very lending which is relied upon for the economy to expand. This creates a vicious cycle that is hard to break.

Central Banks Have Become Increasingly Aware of the Adverse Impact of Low Bond Yields on Financial Sector Profitability

In Britain, the Bank of England (BoE) reacted to offset anticipated economic weakness following June’s Brexit vote by cutting rates, increasing asset purchases, instituting a term lending program and stating acceptance for near-term inflation overshooting. Yet, in the most recent BoE meeting, Mark Carney stated that the economy was holding up better than they had feared. The market read this as recognition of less monetary easing being needed going forward. This further fits with the above themes of monetary policy being overly relied upon, yet ultimately reaching some degree of a hard or soft limit.