- Central banks hesitate to increase interest rates.
- Monetary easing does not manage to fuel inflation.
- If inflation arises stocks should be the best protection.
The central bank of a country determines the base interest rate at which it gives loans to banks who add a risk premium and give loans to corporate and private customers. The base interest rate is therefore the primary factor for the stimulation of economic growth and reach of target inflation.
In the US, the FOMC (Federal Open Market Committee) meets every 6 to 8 weeks and the market and journalists anxiously expect its decisions and outlook on interest rates and the economy. The same meeting schedule applies for the ECB (European Central Bank) monetary policy meetings. The BOJ (Bank of Japan) decides on interest rates in Japan and the PBC (People’s Bank of China) sets the interest rates in China.
The current interest rate in the US is 0.5%, in Europe it’s 0%, in China it’s 4.35%, and in Japan it’s negative with -0.1%. If the economy is weakening the central bank steps in and lowers the interest rate in order to promote more lending that should lead to economic growth. Those should be the reasons behind interest rate changes, however in 2015 the PBC had lowered its interest rate 5 times in order to prevent the Chinese stock market from falling further.
The BOJ brought its interest rate to negative in order to prevent a looming recession, but in Japan’s case the low interest rates have not fueled economic growth. Yes, a negative interest rate means that the bank is paying to lend money to banks, as strange as it might sound, it is the truth.
The US is the first major country that is starting to raise interest rates as its economy seems to be doing better.
It is important to see how this effects the market in the short and long term.
The Last FOMC Meeting and the Implication for Markets
The FOMC met for a two-day meeting on April 26, 2016 and left interest rates unchanged. The other important takeaways are that labor market conditions have improved further even as economic activity appears to have slowed. Inflation is still running below the 2% target.
Concerning the outlook, the FOMC expects that with gradual adjustments in monetary policy the labor market should remain strong end economic activity should improve at a moderate pace. It also expects that the interest rate is going to remain below expected longer run levels.
The implications for investors should be the following and unfortunately all the implications are double-edged swords. A further increase in the base interest rate would:
- Strengthen the dollar as global capital flows would be looking for higher yields with low US risk. A strong dollar, as is already the case, makes exports more difficult and therefore lowers corporate revenues, which implies a return to lower interest rates if the economic consequences are too severe.
- Increase the cost of capital for companies that would consequently lower their earnings.
- Increase returns on bonds, and consequently expected returns on stocks. If expected returns on stocks increase the price usually goes down which reignites the downward economic cycle.
The above examples demonstrate just how difficult it is to set the correct interest rate. Interest rates that are low for too long should create inflation but the ECB, BOJ and FOMC have failed to reach their target of 2% inflation with the current prolonged low interest rates. This proves how the standard economic theory is failing in the explanation of the current global monetary and financial situation and there is no precedent on which to base estimations. Seeing how active the central banks are in supporting the economy and financial markets, it is plausible that the economic standards of the 20th century do not apply to new circumstances. A very important part for the application of the classical economic theory that is missing is inflation.
Surging inflation above 2% would quickly prompt the FOMC to increase interest rates in order to prevent higher inflation rates. With higher inflation rates, stocks should perform well as higher prices increase revenues. Stocks are usually considered hedges against inflation. Bonds should be the worst performers as with higher interest rates and inflation, yields go up and bond values decline.
The US GDP
On April 28 the Bureau of Economic Analysis reported that the US GDP growth in Q1 2016 was the slowest in the last two years. This slowdown also explains the FOMC’s reluctance to increase rates at a faster pace. The reason behind the slowdown is a deceleration in consumer spending and a decline in business investments. It will be important to see if this is the start of a trend or GDP will bounce back in Q2. Also, it’s important to note the fact that as more data becomes available the GDP figures can be revised.
The BOJ and ECB
The BOJ surprisingly did not increase its stimulus for the economy as it needs more time to assess the effect of negative interest rates.
In Europe the policy makers are more eager to improve things as soon as they can. The European Central Bank (ECB) announced last Thursday that it is ready to use “all instruments” available, including further key interest rate cuts plus more quantitative easing.
The above is a lot of information to digest and there is no truth or rule that can help the individual investor. Monetary policies and macroeconomic trends are difficult to forecast and even more difficult to time.
The willingness of central banks to ease monetary policy at the first signs of slowing economies gives a certain perception of security. Until inflation kicks in, the banks have no limits to their easing potential and can fuel slowing economies and declining markets. If inflation does kick in the best hedges should be stocks as corporations can pass on the increasing costs onto the consumer. The financial markets and monetary policies have always been and always will be cyclical. It is up to the individual to assess how much volatility she or he can handle.