By Mike Dolan
LONDON (Reuters) - The healing of global markets in recent weeks mirrors a lull in government and central bank activism around the world - and it may take an even longer policy pause to prevent a relapse.
The New Year market blowout - the worst start to a year in equities for a generation - took investors and policymakers by surprise and threatened to junk government economic forecasts and corporate plans everywhere.
The prospect of a self-feeding downward spiral of investor, banking and business confidence was very real.
As Bank of Canada governor Stephen Poloz said on Tuesday: "As central bankers, we need to take market anxiety and the volatility it creates seriously - regardless of the source."
Poloz blamed what he felt was an unfounded concern that slowing world trade volumes presaged a global recession.
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Yet the shock was rooted in more than trade jitters.
As much as anything, it stemmed from a growing skittishness in investment flows in a slow-growth world with paltry returns, near-zero interest rates, and rapid switches in strategy among both hedge funds and mutual funds struggling to meet, let alone beat, performance benchmarks.
In that environment, a perfect storm whipped up on fears of rising U.S. interest rates and the dollar after December's first Federal Reserve hike in a decade. Deflation jitters were sown by oil's deepening slump, along with angst about the limitations of ever more negative interest rates in Europe and Japan. Chinese devaluation talk abounded, money drained from emerging markets, and doubts grew about the ability of crude exporters to tackle an oil glut.
Against purely domestic parameters, much of this frenetic policy activity and speculation made sense. Collectively, it sparked a firestorm that threatened to burn the whole house down.
TONE SHIFTS
And so, in the weeks surrounding February's Shanghai G20 meeting, the policy tone shifted everywhere. Fed officials made clear they were on hold until June at least. China insisted the yuan was going nowhere fast. Japan and others committed not to step in to direct currency rates. The European Central Bank did execute another mega-easing on March 10, but has stood pat since.
By accident or design, the dollar swooned, oil surged and emerging currencies rallied steeply. Charts of major equity indices trace perfect V-shaped recoveries and have returned to December levels. Corporate and bank borrowing premiums eased.
In turn, Brent crude's 66 percent jump seems to have endured despite a failure to agree a mooted global output freeze as evidence mounted that the 18-month-old price slump was in itself already halting production and crimping supply.
The big question now is whether a resumption of the previous policy activism would merely reignite the volatility too.
A more hawkish Fed would certainly aggravate it. But so too might more extraordinary easing or more deeply negative interest rates in Japan or Europe, by rekindling worries about banks' profitability and central bank impotence or the risk of a long-term policy accident. It might just push markets back to square one.
What is clear, as JPMorgan strategists are at pains to point out, is that the current market rebound owes more to repositioning of funds under pressure to 'chase performance' than any improvement in the underlying economic picture.
While JPM thinks that adjustment may still have legs, the very behaviour suggests it would be premature for central banks and government policy chiefs to assume the coast is clear.
SURPRISING ON THE DOWNSIDE
Citi's 'economic surprise' indices still flash negative for the United States, the euro zone, Japan and Britain, showing that indicators are coming in below analysts' expectations. The aggregate measure for the G10 developed countries has now been in the red all year.
Meanwhile, the International Monetary Fund's latest global growth forecast this month was 3.2 percent for 2016 - half a percentage point below the average of the past 20 years.
In this environment, it is hardly surprising that capital flows are fickle. Barclays annual Equity-Gilt Study shows real U.S. and UK investment returns, already languishing below historical norms for years, were negative in 2015 for all asset classes - equities and cash as well as sovereign, corporate and index-linked bonds.
With interest rates widely pegged near zero, it becomes clear why sometimes modest currency shifts are exerting such influence over capital flows, and how sensitive central banks will need to be in guiding exchange rates.
Morgan Stanley's European equity strategist Graham Seckerat points out that, although gauges of Wall St equity volatility <.VIX> have fallen back sharply since February, global currency volatility <.DBCVIX> remains 10 percent higher than at the start of the year.
"Heightened currency volatility is occurring at a time when the importance and influence of FX trends on equity markets has rarely been greater," Seckerat told clients.
The dollar's retreat on renewed Fed dovishness has been good for U.S. and emerging equity, but the relative underperformance of European and Japanese equity compared to Wall St over the past three months has been the worst in at least 20 years.
"When viewed through this lens it is apparent that a sustained period of dollar weakness is not necessarily a lasting panacea for global risk assets," Seckerat wrote, "and, as ever, too much of a good thing can leave you feeling queasy."
(Graphics by Vincent Flasseur; Editing by Kevin Liffey)