Investing In The Age Of Central Banks

I recently came across the following financial headlines:

“As market rallies back, investors turn eyes to the Fed”

“China’s growth target is the next test for its central bank”

“Credit markets bounce as ECB [European Central Bank] extends QE”

Do you see the pattern?

These days, loyal readers of the Daily Pfennig® newsletter know that it’s hard to find any market news that doesn’t make any reference to the Federal Reserve, the ECB or other major central banks. There’s no question about it; we are living in the age of central banks.

It’s true that investors have always paid some attention to monetary policies. But, these days, investors are not just paying attention; they’re obsessed with what central banks might do next.

And, maybe they have a good reason to be obsessed. A slight change in language or tone in a statement from the Fed or other major central bank can lead to huge moves in the markets. In fact, according to a new study, the Fed’s monetary policy may explain 93% of the stock market moves since 2008.1

The Main Force Behind This Bull Market
According to economist Brian Barnier, principal at ValueBridge Advisors, the Fed’s zero interest rate policy and Quantitative Easing (QE) can explain most of the gains in the stock market since 2008.

Using regression analyses, Barnier showed that during specific eras in the past there was one primary factor that influenced the stock market. For example, mortgage debt in the early 2000s. Starting in 2008, that factor became the Fed’s implementation of its bond purchase program, a.k.a. QE.

He also points out the S&P 500 Index has been moving sideways ever since the Fed concluded its QE program. “Quantitative easing has stopped, but now we’re into the interest rate world,” he said. “That means for any investor trying to figure out what to do, step one is starting with a macro strategy.”2

Indeed, it seems as though predicting the Fed’s next move has become the secret to making money in the markets. For example, Ray Dalio, the head of the world’s largest hedge fund, recently said, “I’m not bearish on stocks.”3

Did he say that because he thinks stocks are cheap? No, not at all. In fact, during an interview about six weeks earlier, he said, “asset prices are comparatively high.”4

He’s bullish simply because he expects the Fed will implement another round of QE. “The next big move I believe will have to be toward quantitative easing, rather than a big tightening.”5

Watch Out For Those Unintended Consequences
This easy money policy has done wonders for the markets since 2008. But, investors should keep in mind that often these policies can have unintended consequences. French economist Frederic Bastiat explained this phenomenon in the 19th century, when he wrote:

“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them. There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen. Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”6

When the Fed cut interest rates to zero and implemented QE, it wanted to prop up the stock market. The idea was that a boom in the stock market would create a wealth effect, leading consumers to spend more money and boost the economy. But, as Bastiat points out, changing the interest rates doesn’t just produce one effect; it produces a series of effects. Oftentimes, they can be ugly effects.

When the Fed cut interest rates in 2002-2003, for example, it wanted to boost the stock market and help the economy recover from the 2001 recession. And, it certainly contributed to the booming markets from 2003 to 2007. But, many analysts also argue that the Fed’s monetary policy during that period played a key role in the housing bubble that almost destroyed the global economy in 2008.

We also have a more recent example: the crash in the price of oil. A new technology known as fracking led to booming oil production in the U.S., which helped drive the price of oil lower. But, some analysts have pointed out the Fed’s zero interest rate policy has also played a role.

In fact, many energy companies took advantage of low rates to borrow money. They used this money to finance very expensive drilling projects that ended up flooding the world market with oil. Now that the oil glut has caused prices to crash below $40 a barrel, the energy industry is struggling. Many oil companies can only be profitable if oil is trading above $50 a barrel.7 As a result, a few energy companies have already gone bankrupt. Some have been forced to cut tens of thousands of jobs. This is a great example of how messing with interest rates, or the price of money, can lead to unintended consequences.

The lesson here is clear. We need to not only pay attention to what central banks are doing, but, to also think about unintended consequences. Today’s policies might be helping boost the stock market. But, as Bastiat pointed out, these policies that create good short-term effect often are “followed by a great evil to come.”

Until the next Daily Pfennig® edition…

Tim Smith
Vice President, World Markets Sales & Servicing Trader
EverBank World Markets, a division of EverBank