Investors Still Pinning Hopes on Central Banks

by Jon Markman | June 8, 2012 9:15 am

Stocks have simply been pounded in the past two months, with the S&P 500 plunging nearly 10%.The reason for the pullback can be blamed on a slowdown in global growth.

As Europe and Asia growth slows, companies in the U.S. that sell into those two markets are simply producing less and, therefore, earning less. To capture more business, these companies are slashing prices. But that’s a little counterintuitive, isn’t it? Now, they’re earning even less than they would otherwise. As a result, margins are coming down, and earnings are being hammered.

Yet, for this week anyhow, investors put aside their fears and pushed stocks higher, with the S&P 500 rallying more than 3% through Thursday. Why the sudden change in sentiment? Well, most investors are looking for global central banks to pull a rabbit out of the hat or shake their magic wand, and stimulate the economy. But the reality is that central banks only have a small number of tricks up their sleeve that will significantly affect the economy.

First, they can cut interest rates. Check. The U.S. Federal Reserve has already cut rates all the way down to zero. And then yesterdy, the Chinese also stepped up to the plate, slashing interest rates by 25 basis points.

Now, after a central bank cuts rates to zero, it has only one move left: Buying bonds to drive down interest rates on things like mortgages. That’s working pretty well so far in the U.S., but it’s not working well enough because unemployment still remains at Depression-era levels.

Rate cutting and bond buying work best if such efforts are coordinated among all central banks in the world. As I mentioned, the Chinese have locked arms with the Fed already, and I wouldn’t be surprised to see Europe follow suit — similar to what these three central banks did back in 2008 to stimulate the global economy together.

How can I be certain? Well, on Wednesday, Janet Yellen, the No. 2 person at the Fed, gave a speech in Boston that was very dour on the economy. She spoke in unusually grave terms.

Although that sounds bad, it’s music to the ears of investors. When the Fed expresses its fear that the economy isn’t working as well as it should, it means that it’s more likely to stimulate. And there is nothing that investors like more than more stimulation, because even though it hasn’t worked so far, it’s expected to work in the future. Investors are always optimistic — and that’s one of the reasons why they bid up risky assets this week.

The next click along this wheel is Fed Chairman Ben Bernanke. He gave his twice-a-year evaluation of the economy to a congressional committee Thursday. As I expected, he didn’t sugarcoat the facts. He noted that the U.S. economy has not achieved its potential, but that he also believes monetary policy has a role to play in improving prospects. Of course, he skirted around the Fed’s next move, not saying exactly what he plans to do.

Despite the Fed taking a “wait-and-see” stance, it didn’t stop investors from speculating that at the next Federal Reserve Open Market Committee’s policiy meeting in two weeks, the Fed will announce further efforts. Investors are hoping to see additional monetary easing, either in an extension of the current Operation Twist, which involves buying bonds to push down interest rates, or a new effort that Fed financial engineers might cook up.

Investors’ optimism was renewed for a few hours, pushing the Dow Jones Industrials up more than 100 points on Thursday before selling heavily into the close. There’s only so much that speculation and hope will buy these days. Now, investors want to see action and results, and if they don’t, then we can expect a return to last week’s lows, or worse.

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