Why advisers and clients need to prepare for the risk of policy error

One of the many aphorisms attributed (correctly or incorrectly) to Mark Twain is the saying: “History doesn’t repeat itself, but it does rhyme”. Tie that in with fund management legend Sir John Templeton’s view that “The four most expensive words in investing are ‘It’s different this time’,” and it is easy to see why investment commentators, as well as advisers and clients, are tempted to draw on the past when it comes to interpreting the present and preparing for the future.

The current bout of financial market volatility has seen share, bond and commodity prices swing about wildly. The action has become more extreme since the US Federal Reserve pushed through its first interest rate increase in more than a decade on 16 December 2015:

Source: Thomson Reuters Datastream. Returns in sterling terms.

However, as the (admittedly iconoclastic) website Zero Hedge shrewdly points out, the markets have ultimately taken a remarkable change in tack ever since Fed chair Janet Yellen announced the US central bank would stop adding to its Quantitative Easing scheme, tapering the monthly scheme to zero on 29 October 2014:

Source: Thomson Reuters Datastream, www.zerohedge.com. Returns in sterling terms.

In sum, stocks have been buried, bonds have continued to perform well and gold has re-entered advisers’ and clients’ consciousness after a few years in the wilderness following its 2011 peak near $1,900 an ounce.

Markets have clearly begun to fret that the decision to stop adding to QE and then raise interest rates represents a potential policy error by the US Federal Reserve, one that could tip the world back into a recession.

This is not the first time the Fed has taken such flak. The US central bank is widely blamed for the 1937 economic downturn and stock market plunge, while 1994’s unexpected decision to raise rates by Fed chairman Alan Greenspan also caused consternation at the time.

In the first instance, the damage was substantial, in the second it proved only temporary for both stocks and bonds. It is instructive to revisit both episodes as this might help advisers prepare investors for any further bouts of monetary -policy inspired uncertainty.

Back to the 1990s

The ejection of a Margaret Thatcher from office after 10 years as Prime Minister, the popularity of Scottish band Wet Wet Wet and the last League Championship victory for a club under an English manager were just three events in the 1990s which brought joy to some, bewilderment to others.

Yet if you ask any financial market veteran about the decade, he or she will probably think immediately of 1995's collapse of Barings Bank, the Asian crisis of 1997-98 and the dotcom bubble that ended it. Ask them to ponder for a moment longer and they will start to shiver and cringe as they recall 1994, a year characterised by a tightening of policy by the US Federal Reserve and market volatility.

On 4 February 1994, without prior warning, Fed chairman Alan Greenspan pushed through the first US interest rate increase and ended a five-year loosening cycle. The Fed funds rate rose from 3% to 3.25% and a quick-fire series of repeat moves took the US headline borrowing cost figure to 5.5% by November.

Bond yields rose (and prices fell) while stocks stumbled too. Yet on this occasion, markets quickly regained their poise. US stock markets rallied hard through to the next stumble of 1997, finally only peaking in 2000, while American bonds recaptured the upward price move (and downward grind in yields) begun in the early 1980s and which continues to this day. The graphics below illustrate market events in the US for simplicity’s sake but UK share and bond prices took their lead from events in New York, so the graphics are also representative of events on this side of the pond.

The Fed’s 1994 rate hike did not fluster stocks for long …

Source: Thomson Reuters Datastream


… as bonds also quickly regained their poise

Source: Thomson Reuters Datastream

On this occasion, US (and global) GDP growth held up well, inflation stood in the mid-single digits and corporate profit growth remained robust, so the backcloth was supportive for security prices.

Whether the environment is as supportive today, with growth below trend and inflation mired near zero, remains an active debate and one that underpins the potential “Fed error” thesis.

Back to the 1930s

When it comes to 1937 the precedent is less encouraging and is potentially more relevant, with current economic growth in the West below trend and inflation mired near zero.

In late 1936, the Fed doubled bank reserve requirements, in effect tightening monetary policy following a huge increase in the money supply between 1933 and 1937, helped along the way by strong inflows of gold into the central bank’s coffers.

The US stock market promptly halved, snuffing out the hard-fought progress made since 1933 as it tried to recover from the 1929 crash.

Some argue the other outcome was the crunching 1937-38 recession, which former Fed chairman Ben Bernanke has referenced many times as a reason why monetary policymakers cannot back off and tighten too quickly this time around.

US stocks plunged as Fed tightened in 1937

Source: Thomson Reuters Datastream

Current affairs

The Fed was on stickier ground in 1937 than it was in 1994, as unemployment was already high and the memories of the Great Depression still fresh, but it did not take much to tip over the economy and the stock market.

In this commentator’s eyes we are closer to 1937 than 1994, owing to the huge debt pile which continues to lurk in the background, feeble growth even after seven years of unorthodox monetary policy and the marked lack of inflation. And also remember that the Fed and Bank of England have long since stopped talking of sterilising their QE schemes and merely brag of having stopped adding to them, while the equivalent programmes in Europe and Japan are scheduled to run until March 2017 and indefinitely respectively.

This shows that advisers need to help clients prepare for the unknown, as monetary policy is reaching limits we have never seen before and the risk of policy error is growing. Markets’ faith in central banks does seem to be fading, something which may explain why gold has had such a good run of late.

The precious metal thrived during 2008-2011 as central banks responded to the Great Financial Crisis by unveiling zero interest rate policy (ZIRP) and QE schemes. And while no-one wants to think that 2008 is the template for current events, even as junk bond yields blow out and set banks’ share prices on edge, perhaps we need to think no further back than eight years, rather than over two and eight decades.

Gold’s renaissance perhaps reflects someone’s view that the Fed will soon recant and start to lower rates and loosen policy with more QE. After all, QE-2, Operation Twist and QE-3 were launched after a 15-20% drop in the US equity market, a move lower in the ISM manufacturing sentiment survey (or purchasing managers’ index) or a sell-off in the junk bond market (or a combination of all three). As the final three graphics show, all of those factors are in evidence today.

Prior Fed moves to loosen monetary policy came after a fall in the US stock market …

Source: Thomson Reuters Datastream


… a weakening of sentiment among manufacturers …

Source: ISM, St. Louis Federal Reserve, Thomson Reuters Datastream


… and/or higher junk bond yields

Source: Thomson Reuters Datastream

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.