If the Market is Always Right, Why are Central Banks Meddling?

One of the first investment lessons about asset markets is that price is king, price is always right. The market will dictate what the price is for an asset. This is a basic tenet of investing in asset markets. The price may be different next year, next week or tomorrow, but today the price is right. This is something all investors agree upon. However, if this is widely held as gospel within the investing community, why are central banks around the developed world waging an unprecedented assault on global asset markets, force-feeding asset prices on markets?

ZIRP and QE

Zero-interest rate policies (ZIRP) and quantitative easing have dominated global central banks for the better part of the last seven years. The US Fed established its Fed funds rate at near zero back in December 2008 and hasn't budged since. In addition to this policy the Fed also implemented quantitative easing, or QE, its asset purchase program to keep longer term rates lower and to inject liquidity in to the marketplace. Both of these policies have been mimicked over the years by various central banks around the globe, some to a lesser extent and others to a greater extent. The latest effort taking place in Europe on  Thursday, September 3rd, where Mario Draghi, the European Central Bank's president, threatened to provide additional stimulus in the wake of the weakening Chinese economy and its potential threat to the Euro Zone's middling economy. The purpose of these policy actions is to manipulate markets. The price of assets are directly affected when the Fed makes a move. But this is normal and happens all the time, right? It is normal and the Fed and Treasury make policy decisions often in hopes to affect markets. That is why they have the ability to make policy changes. If they didn't affect markets, why bother? Although this is all true, it's the extremity and duration of the policies that are twisting markets and not allowing them to function properly.

Dislocations and Misallocations

One of the effects of all the Fed intervention is creating market dislocations. Under normal circumstances, assets price themselves as a function of other assets in the market place. For example, corporate bonds typically price at some function to US treasuries, some spread. Corporate bond prices reflect their inherent risk vs US treasuries through a spread in yield. This spread reflects the premium necessary to adequately compensate investors for the additional risk. During this latest era of easy money, these spreads have been compressed and have not represented the additional risk investors have been taking. This is a problem because it disguises the actual risk that is being taken by the investor, the creditor, and the executive boards of companies that are accessing the capital markets, and creating imbalances.

An additional symptom of the extended current policies is a misallocation of capital resources. Corporations are buying back their own stock and issuing dividends at historic rates. They are doing this financial engineering to prop up stock values and mask the absence of true business expansion through capital expenditures. Companies are not growing so the economy and GDP growth is reflecting this reality, while stock values keep rising. Another misallocation this creates is fund flows from safer investments to riskier investments, often outside of a normal investors risk profile, or better said, the "search for yield." An example of this phenomenon are retirees buying more stocks and less bonds suitable for their normal risk profile, in order to increase revenue.