Central banks low on ammo as Brexit stresses markets

Financial market turmoil from the U.K. Brexit vote couldn't come at a worse time for the world's major central banks.

From the Bank of Japan to the European Central Bank and even the U.S. Federal Reserve, the major central banks are in a tough spot, and are viewed as lacking much firepower to fix anything, given their already extraordinary easing programs. That may make them reluctant to charge ahead full throttle, yet they are still likely to take steps to ease policy to keep global markets liquid.

"I think the bigger issue to us is actually that central banks are pushing the limits of what they can do, and monetary policy was never designed to solve structural issues. We've just had the first major shock coming at a time when there's little scope certainly in terms of traditional monetary policy, and we know that monetary policy has been nominally effective in boosting GDP growth," said Richard Turnill, BlackRock's global chief investment strategist.

The central banks are employing strategies they adopted in the eight years after the financial crisis to boost economic growth, which has never returned to a consistently solid pace. But strategists now say the markets face a political crisis, and the response from policymakers means the world will see low rates for a longer period of time.

The surprise vote by the U.K. to leave the European Union is one of a number of elections in the next year and half, including some key votes in Europe, where nationalism has been on the rise. The fear in markets is that the Brexit result will bring further challenges to the EU, and also the possible dissolution of the U.K. itself, if Scotland again holds a referendum to leave.

"You're facing a number of elections, not least of which is in the United States, which means any significant shift in fiscal policy or structural policy is relatively unlikely. In an environment where monetary policy has less scope to respond, I think we're going to have to be patient to see fiscal or structural policy," said Turnill.

Stocks have sold off sharply, and extreme volatility in currency markets has sent the pound reeling to a 30-year low. Buyers have moved into the safety of bonds, driving yields in the U.K. and Germany to new lows, while the U.S. 10-year appears on a path to retest its all-time low. But strategists note the selling has been orderly and there are not fears of financial systemic risk that characterized the failure of Lehman.

From the market's perspective, slow going may be the best central bank policy for now, since they are already buying billions in bonds and ETFs and have left the world with trillions of dollars in negative-yielding securities.

"I think they're going to move slowly because there's not a lot of room for them to do anything. Could they do more asset purchases? I guess. Could they cut rates a little more negative? I guess," said Jim Caron, fixed income portfolio manager at Morgan Stanley Investment Management. "They could do some of those things, but there's not a lot they could really do here. Money's cheap enough." Caron said whatever they do, he expects only "marginal" effectiveness.

Central banks are considered the market stalwarts when trouble hits, but markets have also lost some of the confidence they once had in them after years of easy policies that have clearly left them with less latitude to act. Speculation focused on new asset purchases, more negative yields and even "helicopter money," a reference to a variety of programs that could put capital into the hands of consumers or into the economy.

The Fed was the one central bank expected to move against the tide of easing, but it now may be forced to hold off on rate hikes even longer than it expected. And while many economists still see a U.S. rate rise by December, the market, based on fed funds futures, is betting on a greater chance of a rate cut by year-end than a hike. Just weeks ago, there were expectations the Fed would increase rates this summer.

There is even market talk that the U.S. central bank could resort to negative rates, but strategists doubt it will go in that direction.

The Bank of England is one central bank that could move forward rather quickly. Economists see a higher risk that the U.K. falls into recession, and Standard & Poor's on Monday cut that nation's AAA credit rating to AA.

The BOE is projected to cut its policy interest rate by a half percent, and BlackRock expects it to restart a quantitative easing program rather than move toward negative yields.

"We think they'll cut to zero, and that will be followed quickly by quantitative easing where they have significant scope," said Turnill. "In the euro zone, we think a move to further negative rates is possible, and more importantly, extending the quantitative easing program is highly likely."

Turnill said he expects the Fed to keep rates on hold for the foreseeable future.

But Japan is widely projected to take action, even though the BOJ saw its move to negative yields backfire, with the yen now much higher than when it announced the program in January.

"The BOJ, we're anticipating the next round of easing to come between now and September," he said. "With the further strengthening of the yen, it's highly possible you'll see further easing there in terms of extending QE (quantitative easing) there as well."

The central banks are stymied in their ability to spark growth, but they have already voiced their support for maintaining stability in markets and they have all been calling on government officials to use fiscal programs to prod growth.

"You don't want to expose that you don't have any ammunition. You don't want to go into a battle saying you're not loaded," said George Goncalves, head of rate strategy at Nomura. "A lot of the stuff is about psychology, making people think you could actually do something. If they were to prematurely ease and not have any merit behind it or confidence it would work, it would be counterproductive. It would be just like when Japan did negative rates in January."

Turnill said central banks need help to push the economy onto a better track. "It needs to shift to fiscal policy. There is limited scope for monetary policy to support the global economy in the face of a negative shock. They are doing what they can. What it is doing effectively is providing liquidity to markets and making sure markets function well," he said.