Has anyone seen the punch bowl?
After a remarkably calm stretch from mid-July to Labor Day, market volatility returned in a big way in the second week of September, prompted once again by the actions (or lack thereof) on the part of major central banks. Yes, we’re aware that we may sound like a broken record with our continuing central banks focus, but in a world of weaker economic growth, low interest rates, and equity markets that have been supported for so long by central bank policy, it should be no surprise that when they speak, investors listen.
In a speech to New York investment bankers in 1955, William McChesney Martin, then Chairman of the Federal Reserve, quipped that the central bank’s task is akin to taking away the punch bowl “just when the party [is] really warming up,” by tightening monetary policy before the economy overheats and inflation takes hold. The volatility that greeted us in mid-September came from investors getting worried about the punch bowls of three large central banks (Federal Reserve, European Central Bank, and Bank of Japan). Since the Great Recession, these punch bowls have consisted of low interest rates (Figure 1) and purchases of securities, which have driven up their balance sheets (Figure 2). We recognize that central bank policy is inherently challenging to predict, and while there will be surprises at times and certainly some disappointed investors, we don’t believe the party will be roaring enough in the near term for the chaperones to crack down.
The first warnings came from the Bank of Japan (BOJ), which acknowledged some downsides of a negative interest rate policy, in which it is now engaged (for short-term rates), along with a massive quantitative easing program (purchasing government bonds and equity exchange-traded funds). The combined effects pushed long-term interest rates into negative territory, with the 10-year yield moving below zero as of March 2016. BOJ comments acknowledged that negative long-term rates can hurt confidence and by extension be harmful to economic activity, damaging financial institutions and other businesses. But it did not take issue with the policy of negative short-term rates. The effect was for investors to start considering whether the BOJ’s next move would be to actively attempt to steepen the yield curve. In some sense, the fear here was not that the bowl would disappear, but that the punch was being swapped out for one with an unknown flavor. At its September 21 meeting, the BOJ indeed followed through with this line of thinking by setting forth a new policy to try and keep the 10-year Japanese government bond at a zero yield. The removal of uncertainty appears to have calmed markets thus far.
European punch: Is this all?
The European Central Bank (ECB) disappointed some partygoers by not delivering a larger bowl of punch after its September meeting. Like the BOJ, it has instituted negative short-term rates and is engaged in a massive bond-buying program, thus pushing down long-term interest rates. Despite the aggressive programs, the eurozone economy remains lackluster with weak growth and very weak inflation. So those who had been hoping for a bigger serving of aggressive action were disappointed by the decision to hold steady.
United States punch: You’re not taking it away, are you?
Of course the U.S. economy is in better shape than either Japan or Europe, so the question here is more like the picture painted by Martin, where the Federal Reserve is considering how quickly to end the party. In the run-up to the Fed’s self-imposed “blackout period” of no public comments for the week preceding a meeting, there was the familiar spate of speeches from committee members. Presidents of the Reserve Banks continued to sound hawkish in wanting to raise rates soon, while Fed governors in Washington, D.C. were much more on the dovish side, seemingly waiting for more evidence that the party is hopping.
One generally dovish bank president did an about-face on September 9, which saw the S&P 500 decline by 2.5% and the Dow lose nearly 400 points. He expressed concern that if rate hikes were delayed much longer, there would be a greater risk of needing to hike faster at a later date, a view commonly espoused by hawkish committee members. Three days later, another Fed governor urged the committee to wait, successfully countering that the risks of pulling away the punch bowl prematurely were even greater than those of keeping the party going. Ultimately the Fed decided to not raise rates at the September 21 meeting, but there may have been a bit of consternation because three members of the policy-making committee cast dissenting votes. We don’t expect a hike at the interim meeting on November 2 for a variety of reasons—not the least of which is that it is just six days before the election. At this point, the Fed appears to be communicating a December hike—which would mark the one-year anniversary of its last hike—and markets are pricing it in.
We expect the punch bowls to stay out for quite some time in Europe and Japan, and the chaperones to only slowly take it away on the home front. The comments in Japan and in Europe certainly surprised investors who were betting on an ever-expanding party. While they may change their tune, their economies remain so weak in terms of growth and inflation that we don’t expect significant changes in our 12-month tactical investment horizon. In the U.S., the recovery continues but has shown enough weakness of late that the Fed is highly unlikely to move quickly after years of telegraphing a “gradual” pace of rate hikes. We expect the slow path of rate hikes to be supportive to the domestic equity market—as our Chief Investment Officer Tony Roth pointed out in September’s Capital Perspectives—but are wary of central bank activity and the impacts on consumer sentiment. In the meantime, would anyone like a glass?
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