Global Central Bank Policy
I suspect that businesses and investment committees around the world are spending an unusual amount of time discussing what central banks are likely to do next. In too many cases this discussion may overshadow those on fundamental trends, product design and relative value opportunities. - Mohamed A. El-Erian, PIMCO
We have been in a policy-driven market now for roughly four years. Both monetary and fiscal authorities have played a heavy-handed role in the economy and capital markets over this time period. Global central bank policy is one of the key things on our Macro Radar due to its post-financial crisis impact on investor sentiment and the performance of both stocks and commodities. The chart below reflects this reality. Notice how the world equity index (blue line) has turned higher around the announcements of the US Federal Reserve's easing programs (QE1, QE2, Operation Twist) and the European Central Bank's long-term refinancing operation (LTRO) while turning lower around the expiration of these programs.
Central banks have worn two distinct hats since subprime first began to topple in 2007. In the early stages of the crisis they focused on the proper "functioning" of financial markets by injecting liquidity and being a lender of last resort to certain corners of the banking system that were completely frozen. This was full on crisis management mode, and policy makers were focused on preventing unnecessary fallout from a temporary state of panic amongst market participants. Once a certain level of stability returned, policy makers shifted their efforts to generating specific economic outcomes such as higher GDP growth, increased lending (go figure), lower unemployment, etc. The primary method for achieving this has been through holding short-term rates at zero and engaging in a practice widely known as quantitative easing (QE) in which the central bank creates new money and uses it to purchase assets such as long-term government bonds in the open market. This has created an added tailwind for US Treasuries and Agency bonds as well as the financial instruments which hold these assets like TLT and AGZ.
The net effect of QE is lower long-term yields and an increase in the money supply which can then be re-invested in other financial assets or spent in the economy. Meanwhile savers are punished for holding cash, and there is a strong incentive to invest money instead in higher-yielding fixed income securities or even riskier assets such as stocks or commodities. This has had a profound effect the performance of high yield bond ETFs like JNK and HYG as yield-hungry investors have been forced to take on more credit and duration risk in today's financially repressed rate environment.
Central bank balances sheets have expanded as they've printed money to purchase assets. An aggregation of developed market central bank balance sheets has tripled from 10% to roughly 30% of GDP in the past five years, and according to a recent report from Artemis Capital Management enough new money has been created to buy every person on the planet a 55" 3D television!
A core belief amongst central bankers globally is that the response to uncertainty should never be paralysis. This is a primary reason why policy makers have been so active in implementing traditional as well as experimental programs in recent years, and why we should expect even more of the same in the months and years to come. In our view, however, monetary policy is becoming less and less effective in actually producing any impact. The developed world faces a twin reality of too much debt and too little growth. Can we really fix overly-leveraged economies with more leverage, and can we really expect to spur sustainable growth by encouraging more borrowing and spending?
While central banks played an integral role in stepping the global banking system through the credit crisis, structural issues in the future will need to be dealt with by the fiscal authorities. Government deficits, debt loads and looming entitlement programs are long-term problems central bankers have no power to address. In the US, Bernanke has already begun warning congress of the potential impact of the upcoming "fiscal cliff" saying, "…there's absolutely no chance that the federal reserve could or would have any ability to offset that effect on the economy." Similarly, Mohamed El-Erian of PIMCO recently (and awkwardly) stated, "In the last three plus years, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable to restore sustainability." Basically all he's saying is that monetary policy may be effective in "extending the runway" so to speak, but longer-term sustainable solutions to the world's problems are going to need to come from somewhere else.
So what's the bottom line?
Whether we like it or not, we remain in a policy-driven market and carefully monitoring and anticipating central bank policy moves can provide an edge growing and protecting one's assets. Let's briefly review the current policy of three of the more important central banks and what can be anticipated going forward.
US Federal Reserve
- The Fed's "Operation Twist" program, in which it sells short to medium-term securities and purchases long-term securities, is coming to an end. The objective of the program is to flatten the yield curve, which can be seen in the stellar performance of FLAT, and push long-term rates down to further incentivize savers to take more risk and move out of fixed income assets as well as to reduce borrowing costs for mortgages.
- Bernanke has signaled to the market that in all likelihood short-term rates will be kept at zero until at least 2014.
- There is much debate over if and when the Fed will implement another round of outright QE (this would be "QE3"). Recently, Bernanke squelched high expectations that QE3 was imminent, citing a relatively stable and growing US economy. This is one of the main reasons for the recent weakness in gold, commodities and all other types of risk assets, and it just goes to show you how addicted the market currently is to policy stimulus.
- We expect that QE3 is an inevitability, although we often debate the timing of when it will happen. The earliest possibility is at the end of June when Operation Twist expires, but we expect that Bernanke will be heavily data-driven and will want to see a material deterioration in economic expectations before making another significant move. For now the Fed is actually revising its 2012 economic forecasts upward.
European Central Bank
- The ECB recently offered 3-year loans at 1% to European banks via its long-term refinancing operation commonly referred to as "LTRO". The purpose of the LTRO was to inject banks with liquidity in order to reduce their reliance on the public bond markets as short-term debt matured and needed to be refinanced.
- The ECB also intended to provide banks with "cheap money" that could then be used to go out and buy higher yielding securities (such as European sovereign bonds) that would generate profits for the banks and increase demand for government bonds that were being shunned by the market. This program succeeded in shoring up the banking system (for now) and pushing yields lower in countries such as Spain, Italy, Portugal and France.
- We see this solution as somewhat conflicted given that solvency issues in these countries have not at all been addressed, and now the banks who were already highly levered to default risk now have even more exposure. James Bevan with CCLA recently stated, "The fragile relationship in which troubled banks support a troubled sovereign which supports both troubled autonomous regions and troubled banks appears now to be failing, and there are no clear paths to either fill or shrink the gap." Exactly.
- We expect more out of the ECB in the future, as it is one of the only lines of defense standing in the way of a collapse and breakup within the European monetary union.
People's Bank of China
- China has spent the last two years tightening policy in order to contain inflationary growth and slowly begin letting the air out of its property bubble. More recently, however, policy has shifted and is beginning to loosen.
- One of China's primary concerns will be balancing growth and inflation. First quarter GDP growth was the slowest it's been in eleven quarters at an 8.1% annual pace, and inflation data has also come down significantly from recent levels.
- Overall monetary and fiscal policy has room to become more accommodative, and we expect that it will throughout the balance of the year. For more detail on our current China outlook see our recent macro update on China's Engineered Slowdown.
Overall the balance of evidence indicates we'll continue to see a healthy amount of monetary policy intervention going forward. In isolation this should be negative for major fiat currencies and positive for commodities, gold, emerging market currencies and even equities in general. However, accounting for central bank policy is only one piece of our macro analysis and needs to be balanced with underlying economic and fundamental realities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.