Financial Post: Central Banks Continue to Come to Rescue of U.S. and Chinese Markets - and it Might Blow Up in Investors' Faces

Article by Victor Ferreira in Financial Post

Fear of the coronavirus hit Chinese markets hard in the form of a one-day eight-per-cent selloff just after the markets re-opened from a layoff for Lunar New Year festivities. With residents of multiple cities confined to their homes and city centers shut down, a deeper and more painful selloff appeared to be a surety. But then the country’s central bank came to the rescue.

The People’s Bank of China immediately injected $174 billion of liquidity into the markets through reverse repos and cut the seven-day interest rate to 2.4% from 2.5%.

“They’re really bringing out the big guns,” said Stephen Innes, who trades in China and is the chief market strategist at AxiCorp. “(But) we’re pretty concerned here, just as people are concerned in the U.S. about the (U.S. Federal Reserve) pumping too much for too long.”

Central banks in China and the United States have both adopted more interventive policies that have kept their markets out of danger. In 2019 alone, the Fed cut rates three times and spent hundreds of billions of dollars to supercharge the repo markets, where central banks buy assets such as government bonds from financial institutions and sell them back for an increased price to create temporary liquidity.

Such a tactic might work in the short term, but there are potential risks associated with bailing out the market, whether it’s in China or the U.S.

Capital Economics chief economist Neil Shearing in a note published Monday said the U.S. is in a Goldilocks environment where low interest rates align with low but positive growth. Remaining in this environment for too long, he said, could cause interest rates to unexpectedly rise and undermine asset valuations that have risen during the U.S.’s longest bull market in history.

In another scenario, the economic environment convinces investors to forge ahead in a “hunt for yield” that causes a “melt-up,” where prices continue to inflate until market bubbles burst. The last time this occurred was when the housing bubble burst in 2008. Before that, it was the dot-com bubble in the early 2000s.

In both the U.S. and China, these solutions do not amount to much more than papering over the market’s cracks, Innes said.

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