Investment Manager Mike Deverell explores how the reversal of central bank policy could impact global markets.
One of the main drivers of markets in the past few years has been central bank policy.
In particular, around the world we have seen vast amounts of quantitative easing (QE) in its many guises. This involves a central bank electronically printing money which they then use to buy (principally) government bonds of their own country. For example, when the Bank of England carried out such stimulus they used the funds to buy gilts and when the US Federal Reserve printed money they bought US Treasury bonds.
The intention is to stimulate the economy by lowering the cost of borrowing. It does that by pushing up the price of bonds which in turn pushes down the yield, thereby reducing the rate at which the government can borrow. This rate is used as the benchmark on which borrowing for company and personal lending are based.
Given that the way it works is by increasing the price of bonds, it is fair to say that fixed interest investors have done very well out of QE. However, as we’ve written about before, we believe this has had just as big an effect on the stockmarket as it has had on bonds.
To illustrate we will focus on the US as there have been some big moves across the Atlantic of late.
Chart one shows how the yield on the two year US Treasury (blue line) has changed over the past 15 years. It also shows the dividend yield on the main US stockmarket, the S&P 500, over the same time period (orange).
Until the financial crisis, bonds traditionally yielded more than equities virtually all the time. A very cautious investor could lend their money to the US government for two years, get a decent rate of interest and know that their investment was guaranteed by the US government. Only the more adventurous investors would buy the stockmarket as they would be relying on dividend and capital growth in order to achieve the same return.
However, since 2008 the yield on the stockmarket has been more than that of the bond, as ultra-low interest rates and QE had their effect.
In fact, by the time we got to 2012 the yield on the two year US Treasury was close to zero. This gave usually cautious bond investors an issue; do they stick with their cautious approach but make virtually no return? To worsen the matter, after inflation they would be losing money too.
Alternatively, they could invest in stocks and get a 2% dividend yield plus the potential for growth. Many cautious investors therefore switched into stocks feeling that the additional income outweighed the risk of investing in stockmarkets.
However, more recently bond yields have been rising and recently the yield on the two year bond rose above the yield on the S&P 500 for the first time in almost a decade. At the time of writing you could get a guaranteed 2.16% per annum by buying a two year US Treasury or receive a 1.76% dividend from the US stockmarket. That comes with the potential for gains but also the risk of losses.
If this trend continues then there could be a point where some of those cautious investors now decide to switch their money back out of stocks and into bonds. That could be the catalyst for a selloff in markets. Given the moves in the past week or so, it’s possible this has already started.
One of the drivers for this recent increase in bond yields has been the increase in rates in the US.
However, we think that is only a small part of the picture and that QE is potentially an even bigger driver.
Chart Two shows the total monthly bond purchases by the major central banks (annualised) over the past few years. Even though the Federal Reserve stopped their QE programme a few years ago, the European Central Bank (ECB) and Bank of Japan (BoJ) in particular have been running their printing presses at top speed.
In fact, the total amount of bonds bought by these central banks has for most of this time exceeded the amount issued by their governments. Essentially, all the new debt issued by those countries has been bought by their central banks. This has helped boost bond and equity prices globally.
Things are going to change this year. The ECB and BoJ will be slowing their QE and, perhaps more importantly, the Fed are essentially going to begin reversing theirs by not replacing bonds as they mature.
Sometime towards the end of this year, the total amount of bonds bought and sold by central banks is going to turn negative. They will be net sellers of bonds instead of buyers.
Meanwhile, at the same time there is likely to be more debt issued this year than last year. To pay for their recent tax cuts, it is estimated that the US is likely to need to issue around $1 trillion of debt this year, around double what they issued last year.
With this new supply and lower demand, we believe that this could indeed affect bond prices. If that is the case then equity investors should also be wary.
In our portfolios we have tried to guard against this threat by holding more alternative equity and property as well as more defensive “short dated” bond funds. We have also diversified our equity exposure away from the more vulnerable areas such as the US and the large multinationals that make up the UK and European indices.