- Financial markets are very dependent on Central Bank activity.
- The FED is slowly tightening, but the activity is more a façade than actual tightening. Europe is still easing.
- The fact is that things will eventually change. When? Nobody knows. The only thing a savvy investor can do is protect themselves and take advantage of everything.
Many don’t see that the current market is highly influenced by Central Banks.
In the past 8 years, Central Banks have been continually putting money into the system. The FED has recently stopped doing so, but the ECB is still buying bonds, even corporate bonds, while the Bank of Japan has bought almost everything they can buy. So, it’s clear that high current asset prices are a direct result of Central Bank actions as the fundamentals haven’t really improved as much as asset prices have increased.
The long-term picture is relatively easy to understand, but I must say, I was surprised by the short-term correlations between Central Bank activity and stock prices.
Citi Research recently released a report that clearly describes how liquidity injections effect the S&P 500 and credit spreads.
Figure 1: Global Central Bank purchases, the S&P 500, and credit spreads. Source: Citi.
The correlation is almost perfect. This means that the money doesn’t really go into the economy, but just inflates asset prices.
Given the huge influence Central Banks have on financial markets, thanks to the market distortion they themselves created, it’s extremely important to listen, or better, to read what the Central Banks’ plans are as the correlations are pretty strong.
Given that the meeting minutes are pretty long and technical, I’ll summarize the FED’s and ECB’s meeting minutes in this article and will provide my commentary on them and on potential future scenarios.
FED Meeting Minutes
The first thing to note from the FED’s minutes is that they have started discussing how to trim the FED’s balance sheet. The consensus is that the FED will create monthly caps and then not reinvest the principal when the bonds the FED owns mature. This cap is expected to gradually increase every year. The starting cap will be $6 billion per month, and then will increase to $30 billion.
So, given that the FED’s balance sheet is at $4.5 trillion, it would take the FED 12.5 years to totally cut down its balance sheet. However, it isn’t in the FEDs plans to go back to the balance sheet levels seen before the financial crisis. So in the short term, the FED is going to tighten, but not quickly enough to significantly to impact the economy.
In the longer term, I find the following extremely important:
Figure 2: Excerpt from FED’s minutes. Source: FED.
So, besides the slow and gradual tightening, the FED is reassuring the markets by saying that if something negative happens, the FED will be there and use all in its power to help the economy. This means that there will be much more quantitative easing when the next recession comes.
What’s also interesting is to look at the FED’s economic projections.
Figure 3: The FED’s projections on GDP, unemployment, and inflation. Source: FED.
GDP growth is expected to be stable and around 2%. I’d agree on the 2% growth, but not on stability. Stability is something that never happens in economics. The unemployment rate is expected to rise a bit as the current levels are below the natural unemployment rate, while inflation is expected to be around 2%.
To sum it all up, if everything goes as planned, interest rates are going to go up to at least cover for inflation and this will have negative repercussions on asset prices, especially bonds and then stocks.
Let’s see what’s going on in Europe.
ECB Meeting Minutes
The situation is very different in Europe. Interest rates are still extremely low and are expected to remain low for an extended period of time, and the European Central Bank (ECB) is still buying €60 billion of assets per month.
The ECB recently mentioned that they might start looking at slowly cutting the monthly purchases if inflation rises and the economy continues to grow.
On the flip side, the ECB will behave as the FED does. If the economic situations worsens, the ECB will take action and pump even more money into the economy.
All Central Banks are heavily involved with what goes on in the economy and financial markets. This is the first negative indication, if there were enough productivity to pull developed economies forward, Central Banks would be marginal players.
The second important thing to account for is that we haven’t yet seen proper tightening in the U.S. and the ECB is still easing.
Figure 4: The Federal funds rate is still extremely low. Source: FRED.
Significant interest rate increases like we’ve seen in the past would quickly lead the economy into a recession, which isn’t a bad thing per se as a recession is necessary to pull the weeds out from the economy. However, after the scare of 2009, nobody is willing to allow a recession. This means that the next recession will unfortunately be another terrible one, but this is a topic for another article.
Thanks to the low inflation rates globally, Central Banks can still play with monetary stimulus and low interest rates. However, this can’t go on forever as sooner or later inflation will pick up. When that will happen, nobody knows. Even Buffett often comments on how surprised he is that we haven’t seen higher inflation levels in the last 8 years. Thus, the only thing a savvy investor can do is to be prepared for anything.
As there is the probability that we won’t see a recession in the next five years, it’s important to be long stocks with a part of your portfolio. However, as it’s always possible that there is a recession around the corner, it’s important to hold assets that will do well in such an environment.
As we know that globally, Central Banks are going to do massive quantitative easing if things take a turn for the worse, bonds will do well, precious metals might do extremely well, and other commodities may give good protection.
In the end, it’s all about portfolio balancing, protection, and being prepared for everything. If there is someone out there who is telling you what, and especially when, something will change in this economic environment, well, that person is just a market pundit. If he or she is right, they will live through their short term glory as have those who predicted the housing bubble in 2006. The fact is that the predictions that followed of all the 2009 gurus weren’t that accurate. It’s possible to know what will happen, but it’s practically impossible to know when it will happen, and there is a big difference in a recession that happens in 6 months or 10 years.
To conclude, nobody knows what will happen. This is the essential nature of financial markets and the economy. Therefore, you can only be prepared for anything by creating a portfolio with the lowest possible risk for the highest possible reward in any economic environment.