- It was William McChesney Martin, Chairman of the US Federal Reserve Bank in the '50s and '60s, who famously remarked that it was the job of central bankers to "take away the punch bowl just when the party gets going".
- Well, the party in financial markets is in full swing. Equities have had a strong run in the last year, with the riskiest markets performing especially well. Euro area equities have risen 25% with Spain up 45%. US equities are up 21%, the UK up 8%.
- Many thought that government bonds would be hit by a global economic recovery and by the withdrawal of central bank stimulus. Instead bonds have risen in value this year with demand for the debt of peripheral European nations surging. In the last year, Greek government bonds have returned 50%. Soaring demand has driven interest rates on Spanish government bonds to their lowest level since 1789; yields on French bonds are at their lowest level since 1746.
- But look at the real economy and the near-euphoria of financial markets looks rather misplaced. The global economy is turning up, but, for most countries, the upswing has not been strong. US growth is running below trend and doubts about Europe's recovery led to the European Central Bank to cut interest rates earlier this month.
- How can we explain the divergence between buoyant financial markets and generally unexciting growth?
- In the last six years, central banks have thrown pretty much everything into the battle to get growth going - record low interest rates, huge programmes for buying up government bonds, schemes to get banks lending and, in the euro area, negative interest rates on bank deposits.
- This has pumped a lot of cheap money into the world financial system. With bank deposits earning next to nothing investors have gone out in search of assets offering some sort of return. The so-called "search for yield" has kicked off again. For an investor faced with the prospect of making nothing on money in the bank an interest rate of 6.3% on Greek government debts looks pretty attractive. So, money has flowed into higher yielding, riskier assets. This helps explain why shares in Swiss banks have made nothing this year while shares in Italian banks are up by 32%.
- Financial markets are in ebullient mood. Volatility, a key measure of stress in markets, is low across asset classes. Markets seem to be counting on interest rates staying low for a long time to come. There also seems to be an assumption that should anything go wrong central banks will provide more stimulus to get things moving.
- The dilemma for central banks is that while financial markets are partying global growth is hardly spectacular. In the euro area, for instance, low interest rates have so far had a much greater effect on equities and bond prices than on bank lending, inflation or growth.
- We think that, in time, easy monetary policy will ignite growth in the euro area, just as it has in the UK. But the worry is that, in the meantime, the party in financial markets could get out of hand, causing asset bubbles and excessive risk taking in just the same way as happened before the 2007-08 crash.
- The central question is whether central banks can ensure a durable economic recovery without creating excessive risks in the financial system. The next few years will provide the answer.
MARKETS & NEWS
UK's FTSE 100 ended the week up 0.9%.
Here are some recent news stories that caught our eye as reflecting key economic themes:
KEY THEMES
- More people are now employed in the technology and information sector in London and the south-east than in California according to a report by South Mountain Economics
- The London Stock Exchange signed agreements with 2 of China's biggest banks to give businesses in China greater access to UK capital markets
- Greece and China signed shipping, trade and energy deals worth $4bn during a visit to Athens by the Chinese premier Li Keqiang, who claimed that Greece should become China's "gateway to Europe"
- Italian and foreign investors are challenging the legality of the new governments proposed cuts in subsidies to the country's fast-growing solar sector
- Research firm IR Japan reported that a record 14 shareholder proposals for higher returns to be made at Japanese annual general meetings this month
- Majestic Wines issued its second profit warning since March, citing slower than expected growth in online sales
- Debt to earnings ratios among European companies were 5.1 times earnings in the first quarter of 2014, above their 10-year average for the first time since 2008 according to Standard & Poor's
- Starbuck's is to become the latest coffee retailer to raise its prices, following an unprecedented drought in coffee-growing areas of Brazil
- The boss of property website Zoopla claimed that the London property market could be more expensive, despite house prices having risen 19% in the year to April
- David Miles, who sits on the Bank of England's Monetary Policy Committee, said it was increasingly likely he would vote to raise rates before leaving the committee next May
- Fast-food retailer McDonald's said it plans to create 8,000 new roles in the UK over the next 3 years, with 2 in every 3 jobs to go to first-time employees under the age of 25
- Discount retailer Aldi aims to double the number of UK stores to more than 1,000 by 2021, possibly adding up to 65 new stores a year
- China's new-home prices fell this year in 35 of the 70 cities tracked by the government, as a result of a slowing economy and excess supply deterred buyers
- Spanish bank Santander is to become the first high-street bank to refer its customers to an online peer-to-peer lender having agreed a partnership with Funding Circle
- Former Bank of England governor Mervyn King commented in an interview that Aston Villa's poor form bodes well for UK growth prospects, as his beloved football clubs fortunes often contrast those of the economy
- Spain's Crown Prince Felipe became King Felipe VI in an austere coronation designed to fit with austere times in the country – devoid of gilded horse drawn carriages, foreign dignitaries or mass – reign check
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