Why you shouldn't position portfolios based on central bank policies

Central Banks policies and actions can lead to short term volatility and also give people like us something to write or talk about. However do not let central banks actions lead you away from your longer term objectives. Let the traders play the volatility while you ride out the short term volatility for longer term gains.

The release of the US Federal Reserve’s (Fed) June 2013 meeting minutes turned markets on a dime. Equities rallied, bond yields fell and US Dollar weakened. Markets were worried about the Fed withdrawing monetary stimulus and had positioned accordingly by buying USD and selling bonds and equities. The Fed’s minutes showed that the Fed Chairman Ben Bernanke wanted to continue monetary accommodation for a much longer period of time than was envisaged by the market.

Bears were forced to cover shorts while bulls gained confidence to go long equities and bonds post the Fed minutes.

Similar situations have played out across the world with markets positioning for one central bank action while the central bank chose to go the other way leaving markets to cover positions with deep losses.

ECB that was at one point of time worried on inflation has pledged monetary accommodation for as long as it takes for Eurozone recovery. ECB has literally thrown away its moral stance on bond purchases. ECB’s see sawing on rates and policies has led to deep volatility in markets as seen by the rise and plunge of almost 300bps in bond yields of Spain and Italy.

Bank of Japan has time and again tried to intervene in currency markets to keep down the Japanese Yen. The move never worked apart from lending short term volatility to the currency markets.

The PBOC (People’s Bank of China) created a liquidity squeeze in China’s money markets by refusing bids from banks for short term funds. Markets reacted negatively to the PBOC move and there were talks of crisis in China due to shadow banking issues. The PBOC then calmed markets by adding liquidity into the system and the crisis issues vanished suddenly.

RBI has time and again acted against market expectations. India’s central bank has either raised rates sharply or cut rates sharply even as markets were expecting moderation. RBI’s focus has shifted continuously with the Rupee (INR) being the primary focus now while growth and inflation have taken a back seat. The INR trading at all time lows has prompted the RBI to curb speculation and put on hold monetary easing that is necessary for the country’s growth. RBI’s focus could change suddenly if the threat to growth is high. Bond markets in India have always lost when trying to double guess RBI’s policy moves.

The bottom line here is that positioning your investments based on central bank policies can only lead to underperformance. You would have to take a longer term view of where economies are headed, levels of asset prices (bubbles or troughs), leverage in the system and other such factors and position your portfolios accordingly.