Why advisers may need to be wary of central bank ‘puts’
Just two months after it halted its Quantitative Easing (QE) bond-buying programme and made vague promises of interest rate increases for the second half of 2019 the European Central Bank is already downgrading its GDP forecasts for the Eurozone and delving once more into its bag of monetary policy tricks. Interest rate increases are on hold until 2020 and the outgoing President Mario Draghi looks set to sanction another Targeted Long-Term Refinancing Operation (TLTRO) – in plain English, a third dollop of cheap cash directed at the banks to prompt them to lend and in turn offer cut-price credit to try and get the Eurozone economy back on track.
Rather than whoop for joy at the prospect of more central bank largesse, equity markets actually sagged, although bond prices rallied and yields fell as markets absorbed the possible implications of downgraded GDP growth forecasts and interest rates remaining lower for longer.
This (very rapid) policy U-turn by Mr Draghi coincides with a similar switch by the US Federal Reserve and further studious inactivity from our own Bank of England. And coming so soon after central bankers had begun to tighten policy, albeit gently, it does raise two questions:
What are the ECB and US Federal Reserve so worried about, that they feel they cannot continue to try and normalise monetary policy? The Fed in particular is actually doing rather well on its twin mandates of inflation and employment and February’s 3.4% wage growth figure, the highest since April 2009, would normally have been enough to prompt interest rate increases.
And if the Fed and ECB stop tightening policy is this a signal for stock markets and other risk assets to head off to the races again? That is what has happened so far this year for sure, as we have seen a huge ‘risk on’ rally with equities beating bonds hands down, with cyclical sectors leading the way and high-yield, or ‘junk’ bonds doing best in a fixed-income context. But can such a surge continue if the underlying fundamentals of economics and corporate earnings are as weak as the need to stop tightening policy suggests?
Central bank ‘put’
The big rally in riskier assets this year looks to largely rest on markets’ faith in the existence of a central bank ‘put,’ namely that if stock and bond prices tumble then the Fed, ECB and others will act to support them, via rate cuts, QE or any other monetary experiment they care to try.
Faith in the ‘Fed put’ has been particularly strong ever since then chair Alan Greenspan waded in with a pair of quick-fire interest rate cuts and a $3.6 billion bail-out plan in the wake of a Russian debt default and the collapse of the Long-Term Capital Management hedge fund in 1998. That set the scene for another leg-up in the 1990s US equity bull run and – in the eyes of some – stoked the technology, media and telecoms bubble that finally burst in 2000.
The mantra among equity investors therefore became ‘Don’t Fight the Fed.’ Yet aggressive interest rate cuts in 2001-02 and 2007-08 did not prevent a US stock market collapse and similar action by the Bank of England initially offered scant assistance to the FTSE 100 either.
First cut is the deepest
This may be why the ECB’s policy shift got such a cool reception last week, because history actually shows that buying stocks on the first rate cut is not always a good idea. This sobering thought is worth bearing in mind, given that markets are now pricing in a 23% chance of an interest rate cut from the US Federal Reserve by December 2019, rather than the pair or trio of hikes that the central bank had been aiming for as recently as Christmas.
The ECB’s relatively limited history means we have a short data set when it comes to interest cycles and their impact on stock markets. But we have plenty of data in the UK and USA.
To start with the UK, the good news is that over the 11 rate-cut cycles since the inception of the FTSE All-Share in the early 1960s, the index has gained after the first decrease in borrowing costs on a three-, six-, 12- and 24-month view. Yet the hit rate over the first three months is patchy (five gains, six losses) and the last two rate-cutting cycles started disastrously for buyers, with losses over a two-year period as recessions bit hard, earnings disappointed and equity valuations proved unsustainable.
Buying on the first rate cut in the UK had generally worked, until the last two cycles
Source: Refinitiv data, Bank of England
As for the US, the data since 1970 makes for grimmer reading. Buyers of US stocks after the first rate cut from the Fed have lost money on average over the past eight rate-cutting cycles on a three-, six- and 12-month view, with the last two being particularly painful, when ‘fighting the Fed’ was actually the right thing to do.
Buying on the first rate cut in the US had generally worked, until the last two cycles
Source: Refinitiv data, US Federal Reserve
We may be jumping the gun here. The Fed is still shrinking its balance sheet, after all.
But Fed officials are already talking about zero interest rate policies (ZIRP) and markets do seem to be asking themselves, in the case of Europe, why the third instalment of the ECB’s TLTRO should create sustainable growth when the prior two rounds did not? And why, in the case of the US and UK, the allegedly temporary measures of a decade ago – namely QE and record-low interest rates – are still required? After all, the architect of the policy in America, then Fed chair Ben S. Bernanke, told Congress in 2009:
Perhaps markets are now taking him at his word and thinking that the economy is still not in the best of health after all, despite ten years of extraordinarily loose policy. And if that did not work, what remedies will central banks try next?