Markets brace for rocky ride after ECB plays last card

By Jamie McGeever

LONDON (Reuters) - The European Central Bank's quantitative easing programme may prove to be major central banks' last salvo in their post-crisis battle to revive growth, heal the financial system and kill off the threat of deflation.

This leaves financial markets more exposed than at any time in the last six years, entering an uncertain world without implicit central bank backing now that monetary authorities have effectively used up all their ammunition.

Having cut interest rates to zero and adopted a range of other unconventional monetary and exchange rate policies that have driven bond yields to their lowest in history - negative, in some cases - central banks' power to drive down the cost of money further and spur risk-taking and growth is waning.

As with the U.S. Federal Reserve's three rounds of QE between 2008 and 2014, the big lurch lower in euro zone bond yields had already happened before the ECB's announcement last week.

Germany's benchmark 10-year yield fell 140 basis points last year, Italy's 220 bps and Spain's 240 bps, all to record lows. A 50 percent collapse in oil prices since June also helped crush yields.

The Fed got even more "bang for its buck", although diminishing returns clearly set in: the 10-year Treasury yield tumbled 200 bps in the two months before the Fed's first round of QE in late 2008; 150 bps between July and September 2011 ahead of "QE2" in November that year; and a further 100 between March and July 2012 before "QE3" in September that year.

So what now? If the QE tide raised all markets, the worry may be that the converse is true now all that liquidity has been pumped in or discounted.

If the first few weeks of January are a guide - notably the Swiss franc undergoing the biggest move for a major currency since global free-floating exchange rates were introduced over 40 years ago - 2015 will be highly volatile for markets.

The Swiss National Bank has spectacularly ditched its three-year exchange rate cap experiment, while the U.S. and British central banks could begin "normalising" policy this year.

On top of that, global growth is creaking. The International Monetary Fund and World Bank both cut their 2015 forecasts this month.

"The reason ECB President Mario Draghi pushed QE out and out and out was because once it's done there really is nothing left - it's the last bullet in the gun," said Anne Richards, chief investment officer at Aberdeen Asset Management.

"We are in for quite a volatile year this year, unquestionably," said Richards, who is Europe's largest independent fund manager, with more than $500 billion of assets under management.

Richards recommends having as broad and diversified a portfolio as possible, including assets as diverse as private equity, infrastructure, and selected emerging markets.

She has never seen so much uncertainty in financial markets in her 23-year investment career. The case for a bruising equity market downturn over the coming few years is just as compelling as the case for the bull run continuing, she said.

CROSSROADS

Major central banks have pumped more than $10 trillion of stimulus into markets since the 2007-08 crash. Among the consequences, a quarter of all euro zone bonds now carry negative yields, according to Tradeweb. More than $7 trillion of bonds globally have negative yields, Bank of America Merrill Lynch says.

This stimulus lifted stock markets from the United States to Germany to historic highs too, while equity and currency market volatility sank to historic lows.

But those tectonic plates are shifting.

"The era when central bank improvisation can be the world's growth strategy is coming to an end," Larry Summers, former U.S. Treasury Secretary, told a panel at the World Economic Forum in Davos last week.

The shift is most visible in foreign exchange. On top of the Swiss franc's unprecedented 30 percent surge on Jan. 15, the euro's slide since last summer and the dollar's broader rise have accelerated in recent weeks.

The greenback's strength is starting to hurt U.S. multinational corporate earnings, and the pain could grow this year if this trend holds up.

These challenges should be partially offset by the ECB and BOJ stimulus, although less of that QE may end up coursing through the global financial system than the Fed's QE.

That's because euro zone and Japanese investors have a high propensity to invest in home markets, said Ewen Cameron-Watt, chief investment strategist at Blackrock, the world's biggest investment fund.

"We're entering a period of divergence and we're seeing that more in the strength of the dollar, so there may be slightly harder sledging ahead," Cameron-Watt said.

"But while QE doesn't promote growth, it is an insurance policy against deflation. It buys a lot of time so, when the dips come along, use them as an opportunity, not a threat," he said.

(Reporting by Jamie McGeever; Editing by Toby Chopra)