Peter Pan, Central Banks and markets

J M Barrie’s Peter Pan had a very strong grasp of the necessity of faith – “Whenever a child says “I don’t believe in fairies”, there’s a fairy somewhere that falls down dead” was written in 1911, and his own ability to fly was critically dependent on his lack of doubt that he could fly.

Ever since the introduction of QE in 2009, markets have had faith that the unconventional actions of the Central Banks would lead to economic recovery. The markets’ expectation of better times ahead itself played a key role in boosting confidence in the real economy, so helping to generate that recovery.

In the last three months however, that faith has been eroding as markets have come to believe that central banks are no longer in control of events. In Japan, the failure to boost QE further at the end of 2014, when the Bank of Japan were expected to do so, closely followed by the adoption of negative interest rates a week after denying they would do so looks like panic. In Europe, Draghi encouraged markets to believe that further ECB easing would be forthcoming in December, only to be unable to deliver it, and then repeated the encouragement that action would be taken in March after market weakness in January. The ECB appears to be a very divided Central Bank. In the US, the Federal Reserve clearly indicated in December when it raised interest rates for the first time in seven years that it expected four further such increases in 2016. Yet markets now assign an equal probability to their next move being a rate cut as a rate hike – the Fed is losing credibility.

Behind all this is the continued deterioration in growth expectations – a year ago there was a general sense that 2015 would see economic recovery around the world as the enormous global monetary easing over the previous six years finally bore fruit. The reality was that once again growth disappointed expectations even with the tailwind of a much lower oil price. Market sentiment is giving up on monetary policy producing economic recovery, and their lack of belief will make it even harder for Central Banks to deliver it.

In particular the move to negative interest rates in Europe and Japan, and the admission by Janet Yellen that the Federal Reserve would also do so if they believed it was necessary has alarmed investors in bank securities, both equities and bonds. Coming as it does with further downgrades to global growth expectations, markets have drawn the implication that central banks themselves are losing confidence that further QE will stimulate economies and thus they are moving towards the idea of negative interest rates. If the Central Banks no longer believe in QE, why should anyone else?

Widespread negative interest rates have not been adopted before – perhaps they will incentivise people to spend rather than save, but that is unclear. What is clear is that negative interest rates are bad news for banks – they have been very reluctant to extend negative interest rates to most depositors, with the result that their net interest margins are falling, at a time when loan growth is slow or non-existent. Banks are the worst performing equity sector so far in 2016.

Markets have now lost faith in the ability of Central Banks to create economic growth – falling bond yields and falling equity prices demonstrate this. To recapture that faith, Central Banks will have to take even more aggressive, unusual and unexpected action.

QE: Farewell or Au Revoir?

The US policy of Quantitative Easing (“QE”) is due to end later this year. Growing uncertainty about the evolution of monetary policy as the economy strengthens is likely to contribute to increased market volatility. Should QE be bade “Farewell” with the economy strengthening, this will mean a less accommodative monetary policy with negative consequences for markets; should it end with the economy weakening, it is more likely that this will prove to be merely “Au Revoir” for QE as it remains the only policy tool available to stimulate a weak US economy. In either case, a period of increased market volatility is likely, and portfolios should therefore remain light in US equities.

The Federal Reserve (“the Fed”) expect to complete their QE programme by 31 October 2014, after 6 years and a $3 trillion increase in the Fed’s balance sheet. The original rationale for introducing QE was to extend the scope of monetary policy after interest rates had fallen to near zero. One of its anticipated advantages was to raise the demand for, and thus the price of, securities in the financial markets. This had the benefit of increasing general economic confidence, as well as reducing the cost of capital for companies who would then be better able to boost capital spending. Forcing liquidity into the financial markets was therefore expected to boost the real economy.

Since February 2009, QE has created a substantial bull market in most financial assets: in Dollar terms, US equities have risen by almost 200%, and global equities by 150%; in addition, yields on all types of bonds have declined to historic lows during this time. The QE programme has taken US financial markets to high levels of valuation, as this injection of liquidity into the financial system has sought to find a home.

Looking back at market movements in recent years, the stock market moved steadily upwards during each phase of QE, but tended to be much more volatile when QE was not the Fed’s declared policy (in mid-2010 and from mid-2011 to mid-2012) .  Alongside lower bond yields, equity markets have become much more expensive during the phase of QE. QE has been a supportive factor for the US stock market, and we have noted previously that most of the rise in global equity markets in recent years is accounted for by rising valuations rather than rising earnings.

The effect on the real economy is less clear. Bank lending to US companies has risen, but little of that lending has been spent on capital investment. Instead, additional lending has funded large share buyback programmes and merger and acquisition activity by US companies. Both of these activities boost demand for shares in the stock market but do little for growth prospects in the real economy.

QE1 was very effective in stabilising the market for a number of credit instruments and economic growth rose from -4% to +3% while it was in operation. Since then growth has remained between 1.5% and 3% despite QE2 and the far larger programme of QE3, which have both been conducted in the face of muted economic growth. This level of growth has been disappointing when compared with a normal level of growth of 3% or more since the 1980s, and typically much faster rates of growth when recovering from recessions.

It is interesting to note that both QE2 and QE3 were initiated at about the same time as economic growth began to slow. This indicates that (i) the Federal Reserve has a low tolerance for a weaker economy, and (ii) with interest rates already at zero, if they fear a weaker economy, their only response has been a new and larger QE programme. It is likely that markets would interpret any re-introduction of QE as a major failure for the Fed.

The recent decision to bring QE to an end by October 2014 was based on the Fed’s forecast that growth will rebound to 3% from the second quarter and stay there for the next few years. However, the US economy has only managed a 3% year on year growth rate in three quarters since 2008, so this would require a substantially healthier economic performance than has been seen for some time. It is quite feasible that the economy will weaken again once QE has come to a halt, in which case the Fed may feel obliged to restore a QE programme since there are no other obvious policy options. This would be seen as very negative by markets as it would highlight the US economy’s lack of ability to grow without extraordinary policy action.

The introduction of QE was a new experiment in monetary policy when introduced, with no one really understanding how and whether it would work and the size of the programmes that would be necessary. Equally, ending QE (and at some point, reversing QE) will also be experimental, and the effects on markets and the economy are unknown. The experience of Japan early this century, and the two short-lived attempts to end QE in the US in the last few years, has been that markets react negatively to an early withdrawal of liquidity, and that this damages confidence and sentiment in the wider economy. The Fed is hoping that economic recovery is (i) more firmly established than the current GDP data imply, and (ii) able to withstand the negative effects of less demand for market securities from QE. The current trajectory of unemployment suggests that the US economy is indeed self-sustaining and, to date, QE has been wound down without adverse consequences. However, if the withdrawal of QE does stall the recovery then it will be very difficult to kick-start the economy again, since the Fed will be left with few policy options other than renewed and magnified QE.

Throughout 2014, we have been expecting (i) more muted returns from markets than we saw in 2013, on account of this change in policy by the Fed, and (ii) greater volatility in market prices as QE was tapered and then eliminated.   Market returns have certainly been more muted so far in 2014 but they have adapted to the tapering of QE without a rise in volatility. However, the looming prospects of tightening monetary policy and rising interest rates, though positive for the Dollar, are likely to cause problems for US equities, and we remain light in US equities across our portfolios.

The Global Monetary Policy Kaleidoscope

In 2009, in the face of a global economic crisis, the major economies of the world came together and acted in concert to ease monetary policy aggressively.  Together with fiscal stimulus in the US and China, these policies helped to prevent the world from slipping into depression.  Four years on, the economic conditions around the world vary enormously, and the appropriate monetary policies are now very different (though for all countries fiscal restraint is deemed necessary).  These differing monetary policies are producing clear differences in how the local financial markets are performing, and in 2013 there has been a much greater dispersion of performance between equity markets around the world than in 2012.

The economy with the most aggressively easy monetary policy (relative to the size of its economy)  is currently Japan, where in response to the lead of the new Prime Minister, the new Bank of Japan Governor has begun a programme of doubling the country’s monetary base in just two years.  This is being done deliberately to raise the rate of inflation in Japan from the negative rates seen in recent years to the new target of 2%.  To bring Japan out of its 20 year deflation, policymakers have articulated that inflation, and inflation expectations, need to rise to boost the nominal growth rate of the economy.  Should the current policy settings not be sufficient to do this, it is expected that policymakers will move monetary policy to an even easier stance.  The weaker yen that is likely from this policy should be instrumental in helping to boost inflation.

Next is the US, where currently the QE programme is about $4bn of new money creation every day that the financial markets are open.  Before the latest Japanese policy move, this constituted the most aggressive monetary easing.  However, the recent furore following Bernanke’s comments about the tapering of the QE policy indicate the sensitivity of markets to changes in the direction of US monetary policy.  Bernanke tried to argue that tapering a policy of printing $4bn every day to one of printing $2bn or $3bn was still a very accommodative policy; the markets however appeared to interpret it as a tightening of policy.  The rise in US bond yields since May shows that a policy that is easy, but less easy than it was, creates different expectations in the minds of investors, and the Federal Reserve’s words have thus changed the thinking of investors.

Both the ECB and the Bank of England are at a similar phase in their monetary policy.  Both have pursued unconventional policies in the past, the ECB with their three year LTROs and the Bank of England with their own QE programme, but have done little recently to move policy easier.  However, the new Bank of England Governor has clearly been tasked with boosting economic growth in the lead-up to the next election, and the ECB is concerned about the continued poor performance of the Eurozone economy.   The recent rise in bond yields that began in the US and spread across the Atlantic has been unwelcome as it raises the cost of borrowing for business and so offsets the otherwise easy policy in both the UK and the Eurozone.  A further easing of monetary policy can therefore be expected from both Central Banks, and crucially, for markets, the direction of monetary policy is still moving easier, in contrast to the US.

In China, markets have been surprised by the actions of the People’s Bank of China in not providing sufficient liquidity for the interbank market to operate smoothly in the face of liquidity pressures.  This caused overnight interest rates briefly to move above 10%, and has been interpreted as a lesson to the banking system that they have been too carefree with their lending and need to cut back.  This is effectively an act of policy tightening, though it is unlikely that the Chinese will take such tightening too far and seriously damage the economy’s growth prospects.

Finally, there are a number of significant emerging markets such as Brazil, Turkey, Indonesia and India where Central Banks have actually raised interest rates or have indicated an intention to do.  For the most part, this has been due to currency weakness, which boosts inflationary pressures in these economies, and so a tightening of monetary policy is believed to be required, in contrast to most of the rest of the world.

The league table of the stance of monetary policy, which runs from Japan, the US, the UK, Europe, China and Asia and then other emerging markets correlates precisely with the league table of year-to-date equity market performance.  Those countries with the easiest stance of monetary policy are those whose stock markets have performed best, and those with the tightest policy stance have performed worst.  This highlights the increasing dependence of financial markets on the liquidity provided by Central Banks, rather than fundamental economic and earnings trends.

Looking forward, we would expect Japan to remain at the top of the easy monetary league, with the UK moving up and the US moving down in the next few months, and the Eurozone having little room to make any changes.  China’s slowing growth will eventually produce an easier monetary policy, but may not be imminent, while the other emerging markets appear to be the furthest away from easier policy.  Japan and Asia remain the most favoured markets in our portfolios with Europe and Emerging Markets the least favoured.

Fed up – down with QE?

Ben Bernanke’s discussion of the Fed’s policy intentions in the press conference following the Federal Reserve meeting on June 19 was a shock to markets, with all asset classes around the world falling sharply in response.  His remarks, together with the Fed’s revised economic forecasts for the US, indicate that the policy of QE will begin to be reduced when the unemployment rate falls below 7.5%, and would be stopped altogether when the unemployment rate falls below 7.0%.  Interest rates would only begin to be increased when the unemployment falls below 6.5%.  On the Fed’s economic forecasts, QE would begin to be tapered in September, and end by next summer, with interest rates beginning to be increased in 2015.

Financial markets were very surprised, and for five reasons as follows: (i) the Fed’s latest economic forecasts are optimistic regarding growth and inflation over the next eighteen months  – the Fed expect growth of about 3% over this period, faster than at any time since the crisis, and inflation rebounding to about 2%; (ii) the Fed’s forecasts for growth in 2013 and 2014 are lower now than they were last September when they announced the latest round of QE; (iii) Bernanke has always been very clear that the errors of US economic policy in the 1930s and Japan in the 1990s, following banking crises, lay in the authorities tightening policy too early and before the economies had fully recovered – it was thus expected that he would be slow to reverse QE; (iv) the rest of the global economy is not in a very fit state to cope with this move – Europe remains in recession, the Chinese recovery is not coming through as fast as had been expected, and Japan is just embarking on its own massive round of policy stimulus in an effort to revive its economy; and (v) Bernanke said it was significant that the total amount of QE would still be rising which  indicated easier monetary policy (i.e. lifting the foot off the accelerator) , whereas the markets focussed on the fact that it represented a change in the momentum of QE, and so see it as a tightening of monetary policy (i.e. putting the foot on the brake).

If Bernanke, and the Federal Reserve, are correct in their judgement that US economic growth is about to move higher, then future historians will judge Bernanke very well.  For over five years he has maintained near zero interest rates and extraordinary levels of money creation, which has allowed the US economy to perform better than the other developed economies.  Should the economy accelerate while coping with an ending of QE, as the Fed’s forecasts imply, he would be seen as having exercised tremendous courage during the crisis in adopting QE and tremendous judgement in reversing course and ending QE.

In recent years however the Federal Reserve’s forecasts for growth have been consistently over-optimistic, as the pick-up in consumer and business confidence and spending, which was the objective of QE, has been very slow to materialise.  Seen in this light, discussing the Fed’s policy intentions so openly may be seen as unwise.  If the expected growth acceleration does not occur, the markets have been given an unnecessary and unpleasant surprise, which would make it even more difficult to raise confidence and spending.

There are also other interpretations of the motivation behind Bernanke’s comments.

  1. The most likely is that the behaviour of financial markets in 2013 (up until Bernanke’s comments to Congress on May 22), which saw both bond and equity markets moving steadily higher whether the economic newsflow was positive or negative.  Markets appeared to be responding not to fundamental news but to the provision of liquidity from the QE policy – a feature typical of market bubbles.  By clearly discussing the potential to reduce or end QE, the liquidity support for markets is removed, and any bubble is pricked.
  2. Bernanke’s term as Chairman of the Federal Reserve ends next January 31, and the indications are strong that he will not be seeking to continue.  It may be that he does not want to leave office with a legacy of the most extreme, loose monetary policy that the US has ever employed, and is therefore keen to begin the process of returning policy to more normal settings.
  3. The most bearish (and least likely) interpretation is that he and the Fed no longer believe that the QE policy is capable of delivering growth, but that the risks of the policy, in terms of the scale of the money creation and potential inflation, are now too great.

Some immediate market implications are clear.  Bond investors were happy to continue buying bonds all the time they believed that the Federal Reserve would also be buying them through QE.  From 2003 to 2008, the Asian Central Banks pursued a policy of reinvesting their large trade surpluses into US bonds to prevent their currencies appreciating. From 2009 to now, the Federal Reserve has taken over the role of the lead buyer of US bonds.  The Fed have clearly signalled that they believe this period is near to an end – in the absence of a forced buyer, bond yields are likely to move towards more normal levels.  It will take a much slower economy and a return to QE for bond investors to become confident enough to become buyers again.  This move to higher yields is however likely to slow growth, and lead to lower valuations for all financial assets.

We expect growth not to meet the Fed’s forecasts, and so not trigger the pace of withdrawal of QE that Bernanke set out in the press conference.  Such an outcome is likely however to create confusion and uncertainty in financial markets over the next few months, as investors seek to guess the Fed’s reactions to every piece of news. Bonds are unlikely to perform for some time, and investors should look to reduce positions. Equity markets are not expensive but the outlook for growth is not exciting, except in Japan, and investors should wait for a clearer picture of the global economy to emerge over the summer, before making any significant changes to portfolios

From Heroes to Zeroes – 21st Century Central Banking

At the beginning of this century, the reputation of Central Banks in the West was at its apogee – over the previous 20 years inflation had been wrung out of the global economy by maintaining interest rates consistently higher than the rate of inflation. If inflation threatened to rise too sharply then raising rates by a few hundred basis points was sufficient to choke off consumer demand (since their mortgage repayments formed such a significant part of their disposable income) and slow the economy and inflationary pressures. Once this had been achieved, often requiring a quick recession, rates could be cut again and the restoking of consumer demand would reignite the economy. In short, it was apparent that Central Banking that had as its main target the control of inflation could be successful at only a small cost to growth. Politicians found themselves able to give up their desire to control interest rates for electoral purposes and give independence to their Central Banks. Central Bankers became Heroes!

The recession in the US following the bursting of the internet bubble and fears for the US economy following 9/11 however, saw the Fed cut US rates right down to 1% in 2002 and hold them there until 2004. 1% interest rates were much lower than seen in previous cycles and in hindsight were responsible for a massive inflation of the US housing market. Whilst the internet bubble was essentially financed by equity, since the new companies had no cash flow, the housing bubble was financed by debt. Debt-financed bubbles we now know inflate far further than equity-financed bubbles and then burst in a far more devastating fashion. Central Banks meanwhile, focussing only on the Consumer Price Inflation targets did not spot the bubble in the debt markets and so did not increase interest rates sufficiently to manage things better.

Following the 2008 meltdown in the global financial system and subsequent recession, Central Banks found that even interest rates that were effectively set at zero no longer helped to boost consumer demand. This was for two reasons, first consumers realised that they had already got too much debt and no longer wished to borrow more, even with low interest rates and secondly the all economic agents (banks, companies and consumers) had lost confidence in the future growth prospects of the economy that they did not want to lend, borrow or spend.

The Central Banks went back to their old textbooks to search for policy tools when interest rates can no longer be reduced and discovered Quantitative Easing (QE) which pushes money into the financial system in an effort to boost the demand for financial assets and thus stimulate the real economy. Many Zeroes of dollars, euros, yen and pounds have been created in this way. QE has almost certainly worked in the sense that economic growth in 2009, 2010 and 2011 would have been much worse without this policy, but it has not been enough to boost growth back onto a sustainable path. Worse still, repeated applications of QE seem to be less effective at doing this than the first effort. The scale of these interventions has brought forth much criticism of Central Banks in the US and the UK for creating the risks of hyperinflation from the creation of so much money. In Europe where monetary orthodoxy of the Bundesbank is enshrined in the ECB’s mandate, the Central Bank is criticised (outside Germany) for not doing enough to support the Eurozone economy.

For politicians, who are policy-constrained by huge fiscal deficits and debts, the only hope is that Central Banks solve their problems, but whilst Central Banks have the tools for fighting inflation, they do not have the tools for fighting deflation. They have done what they can (zero interest rates and QE) but have little more to offer bar providing liquidity to keep troubled banks alive and adding more zeroes to the money supply. The Age of the Heroic Central Banker is now behind us.