As we near the end of our “Adventures on the Planet of the Apes” blog series, we are in tumultuous times. We anticipated the next downturn would mark a further step toward loose monetary policy, piloting toward zero or negative interest rates and more asset purchases. It appears as though we have now entered that period.
When central banks were forced to admit that they had pushed rates so low their lungs can no longer be squeezed to breathe life into the system, we anticipated a shift to fiscal policy stimulus. We believed the fiscal regime would come about when monetary policy was perceived to be out of bullets. The rapid emptying of the last of the central bank chambers has been hastened by COVID-19 reactions, to be sure. However, these chambers were close to empty even before the pandemic’s impact from just a couple months ago.
While some will assert that this (central banks’ empty ammunition chambers) describes the current situation in the United States and other developed economies, we disagree and we do not believe that it yet represents conventional wisdom. Eventually, and we’ve seen evidence of this just in the past month or two, governments and central banks will proclaim that they are the joint protectors of the world from prolonged malaise and portend the culmination of the current inflation-targeting regime.
In the meantime, inflation-targeting regimes may dominate for as long as another 10 to 15 years. During this time, we expect interest rates to remain low with real rates negative in most rich countries. 1
The closer central banks are to running out of ammunition, the more eager they are to respond to any sign of economic or market weakness.
It seems that the closer central banks are to running out of ammunition, the more eager they are to respond to any sign of economic or market weakness. Such stimulative monetary actions are unlikely to disappear as a palliative to financial market woes.
When markets started shaking back in late 2018, the Fed took a sudden dovish turn that killed all expectations of rate hikes. Outside the United States, the ECB stepped in on news of economic weakness in September of 2019 with a further cut to its deposit rate to -0.5%.
In response to the new coronavirus that emanated from Wuhan, the People’s Bank of China injected a record-amount of liquidity in early February of 2020.
Monetary policy is still the first line of defense to stem volatility and uncertainty. As long as stimulus persists, we will not assume that prices move toward fundamental values in anything resembling a straight line.
The U.S. repo incident in September 2019 signaled how hard it will be for the Fed to shrink its balance sheet. As long as the balance sheet was growing and new reserves were being supplied to financial institutions, the repo market seemed to function smoothly.
When even a small step toward normalization causes an earthquake, there is something seriously wrong.
While the Fed does not know exactly what “balance sheet normalization” is, it is safe to say that it will unlikely be its first choice going forward. We expect to see more liquidity events like the September 2019 U.S. repo market debacle.
During these periods, we will look for opportunities to provide liquidity and use our unencumbered cash to take advantage of rate discrepancies and suppressed prices.
The eurozone and Japan, meanwhile, are close to losing the credibility of their monetary regimes and are thus likelier than the U.S. to see policies shift toward new fiscal measures the next time central banks try to rescue the economy from a recession. This shift would give asset prices a final boost, increase the value of inflation protection, and push bond yields higher.
Expecting most interest rates to stay low for a long time yet, we deem the fundamental values of equities to be higher than they otherwise would be (in normal circumstances). Value indices may continue to struggle in this environment against their growth counterparts.
Several markets in Europe, as well as several emerging markets, are attractive on a risk-adjusted, long-term fundamental basis thanks to our outlook for another decade (or more) of low rates. This is a forestalling of the rate increases that we anticipated in our Navigating a Troop of Gorillas series.
Next up: The negative consequences of low rates.
1 Changes in regimes do not come easily and central bankers will hardly be eager to give up the keys to the economy-car. The last time the United States saw fiscal take over from monetary policy was under President Nixon who, seeking to be reelected in 1972, virtually forced Fed chairman Arthur Burns to keep rates low despite rising inflation (Bianchi 2912). On the other hand, during the great depression, government wanted more monetary and the central bank more fiscal policy (Meltzer).
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Adventures on the Planet of the Apes Blog Series
Part 1: Navigating the Low-Rate Environment
Part 2: Nothing Natural About Low Rates
Part 3: Why Rates Are Low
Part 4: Where Is the Inflation?
Part 5: The Death of the Inflation Regime
Part 6: Beyond the Inflation Regime Collapse
Part 7: Rates: Lower for Longer
Part 8: 6 Negative Consequences of Low Rates
Brian Singer, CFA, partner, is a portfolio manager on and head of William Blair’s Dynamic Allocation Strategies team.