Central banks take centre stage once more

The European Central Bank’s decision on Thursday 10 March to unveil a new four-pronged stimulus package begins a key week for policy decisions from the world’s leading monetary authorities. After President Mario Draghi’s latest moves to:

• Cut the headline interest rate to zero from 0.05%
• Cut the deposit rate to -0.4% from -0.3%, increasing the cost to banks of parking their cash with the ECB
• Increase the size of the monthly QE scheme by 33% to €80 billion from €60 billion
• Increase the scope of QE to include corporate as well as government bonds

Investors can look forward to the following interest rate announcements next week:

• Bank of Japan on Tuesday 15 March
• The US Federal Reserve on Wednesday 16 March
• Our very own Bank of England on Thursday 17 March

Investors have two options when it comes to central banks and interest rate decisions.

• First, ignore them. You can adopt the line followed by legendary investor Warren Buffett and argue that economics and policy are unforecastable. The Berkshire Hathaway boss suggests you are better off focussing instead on individual stocks to try and identify those whose competitive position mean they have the pricing power that in turn translates into predictable cashflows and dividend growth over the very long term.
• Second, keep an eye on them. Interest rate and interest rate expectations are an important part of equity valuations, especially for discounted cash flow (DCF) calculations, so their direction and pace of travel can be important.

Which of these approaches works best will be down to an investor’s specific personal circumstances, investment goals and time horizon but for the moment markets appear to remain torn between

• Faith in central banks’ ability to fuel an inflationary recovery
• Fear of a deflationary downturn

The latter prevailed in January and February, especially as economic indicators remained spotty, with the one exception of unemployment, which is a firmly lagging indicator.

Checklist of key economic indicators for the big four central banks

Source: Thomson Reuters Datastream, ISM, CIPS/Markit, ONS, BLS, Eurostat, BoJ NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

However, stocks and commodities have rallied in March, buoyed by hopes for more monetary stimulus – the self-same monetary stimulus which markets initially concluded had failed to work when Japan took a commercial bank deposit rate into negative territory, after a mere 21 years of headline interest rates below 1%. Given such unpredictable switches in sentiment, perhaps investors should switch off the TV and radio next week (and perhaps even stop reading the rest of this column).

Central bank policy checklist and timeline

Source: ECB, BoJ, Federal Reserve, BoE NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Japan

The Bank of Japan will offer its latest policy move on Tuesday 15 March, alongside comments from Governor Haruhiko Kuroda.

The BoJ has already increased the size of its QE scheme to Y80 trillion a year (some £500 billion a year) and added longer-dated bonds and equity ETFs to the assets it can buy. In February it cut the headline interest rate from 0.1% to zero and took a deposit rate for commercial banks down to minus 0.1%. Patchy economic data mean Kuroda-san may act again, not least to weaken the yen and try to boost exports, as the currency has surprisingly rallied against the dollar in 2016, as shown by this chart here. Japan doesn’t want a strong currency so it can try and export its way to growth (just like everyone else).

After 22 years of zero interest rates Japan still can’t fire inflation higher

Source: Thomson Reuters Datastream NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

The USA

The US Federal Reserve releases its latest policy decision on Wednesday 16 March. This is the biggie. When chair Janet Yellen raised rates by a quarter-point to 0.5% in December, the Fed’s own forecasts implied four more hikes this year to 1.5%.

US inflation has started to move toward the Fed’s 2% goal

Source: Thomson Reuters Datastream NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

One of the eight meetings has been and gone, this is the second but the market is increasingly of the opinion now that the Fed may leave things alone until 2017, although early March’s apparently strong jobs figures mean some still see an increase in June. There’s little expectation of a rate rise next week but check out the statement for any hints of action. No move is likely to be taken as good news, hints of a rate rise may cause some volatility, judging by the May 2013 taper tantrum, summer 2015 wobble and post-rate rise stumble in stocks this year.

UK

The Bank of England’s Monetary Policy Committee meets on Thursday 17 March. The last meeting saw Governor Mark Carney and the MPC vote 9-0 to leave interest rates unchanged at their record low of 0.5% and leave QE at £375 billion.

No-one expects any action from the Bank of England next week and some even think the first UK rate rise will come in 2017, although MPC members Nemat Shafik and Martin Weale have both been jawboning that rates could rise faster than the markets think, even if inflation is miles below the 2% official target.

UK inflation is still miles below the official 2% target

Source: Thomson Reuters Datastream NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

We have however heard that line from others before and the latest manufacturing, construction and services sentiment surveys, or purchasing managers indices, were all disappointing.

UK sentiment surveys are heading lower

Source: Thomson Reuters Datastream NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

A sudden dash to jack up rates now seems unlikely, especially since the UK economy has been decelerating for some time now, as the year-on-year GDP growth numbers show.

UK GDP growth looks to be losing momentum

Source: Thomson Reuters Datastream NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Given this and the uncertainty over the Brexit vote, it’s hard to see Mr Carney choosing to rock the boat.

Sound and fury

Whatever happens, central banks will be strutting and fretting their hour upon the stage next week and markets will be listening. Whether this all proves to be a tale told by an idiot, full of sound and fury, signifying nothing remains to be seen but this is how the major asset classes have done since the Fed raised rates in December: gold and bonds have done best with stocks and commodities bringing up the rear (in local currency terms).

Gold and bonds have done best since the Fed’s rate increase

Source: Thomson Reuters Datastream NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Let’s see whether these trends persist or not but gold is traditionally an inflation hedge – and it’s doing well even as central banks fail to meet their 2% targets. Perhaps the market, via gold, is saying that central banks won’t rest until they succeed, even if this means lower interest rates for longer and maybe even more QE.

After all, every developed market central bank to have raised rates since 2009 has subsequently had to backtrack and cut them again. This may explain why the markets do not believe the Fed will follow through on its December ‘dot-plot’ forecast of four additional 0.25% rate increases in 2016.

Central banks have generally backtracked on plans to tighten monetary policy

Source: Thomson Reuters Datastream NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Currency shuffle

Note also how equity index performance has flipped around since the Fed moved to increase rates last December. Japan and Europe have plunged to the bottom of the rankings hampered by strength in the yen and euro, as the markets have taken the view the Fed may not hike as aggressively as initially expected. That has also stopped the dollar in its tracks, giving emerging markets (and US stocks) some welcome respite.

Yen, euro and dollar movements have greatly influenced stock indices after the Fed’s December hike

Source: Thomson Reuters Datastream NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

This also shows how important currencies are right now, besides suggesting that if the Fed did surprise with tighter policy while Japan and Europe loosen, the latest trends could reverse, with yen and euro weakness boosting stocks there and dollar strength taking the steam out of emerging markets.

Russ Mould,
AJ Bell Investment Director