Investors Beware: What’s Next For Central Banks

Power to the people, rather than the authorities, as central bank action fails to deliver  

Editor, Europe
Reviewed by: Rachael Revesz
Edited by: Rachael Revesz

Recent events suggest power is to the people, not to central banks or governments. Anti-austerity party Syriza is back in power in Greece, putting bail-out monitors to the test, while in the U.S., Europe and China, authorities struggle to contain their economies and stock markets. The news that China’s government failed to prop up its own equity market, while the U.S. Federal Reserve didn’t twitch on interest rates, has led some commentators to suggest they are losing credibility. speaks to Paul Jackson, managing director and head of multi-asset research at ETF provider Source, to get his views on what the central banks plan to do next. What was your reaction to the Fed halting rates last week and what does their decision mean for future action?

Paul Jackson: I can’t say it was a surprise that they didn’t raise rates this time. I’ve said for some time that in December they will make their first rate hike. For the next few months it’s a case of waiting for the data flows to come in and for the markets to assess whether those data flows are pushing the Fed in the direction of that rate hike. The important ones will be the labour market: not only jobs growth but also wage growth, and keeping an eye on retail spending, consumer spending and by the time we get through to December we’ll have the third quarter GDP figure. You’ve said before it’s rare for investors to lose money on the S&P 500 or 10-year U.S. Treasuries during rate-hiking cycles, so why do markets still react to Fed action?

Jackson: I think there’s a common belief that when the Fed raises rates it’s bad for a whole range of assets. It's not surprising, given the performance of fixed income is often not as good during Fed rate hiking cycles. When rates go up that is an impediment to the returns from fixed income products. When rates go up, prices go down. It’s just a question whether the income you’re receiving outweighs the price losses. You can understand why people might think they will lose money.

On the equity side I think it’s one of these myths that when the Fed raises rates equity investors are losing support and that has to be bad. But I’ve done a lot of research on rate-hike cycles going back to the 1930s and the main equity markets may take a bit of a breather when rates are raised and that maybe lasts for a month or so and then beyond that month, month and a half, that equity market takes off again. So the facts don’t always bear out the myths. Is all this delay and back and forth making central banks lose credibility and their hold over the economy and markets?

Jackson: There are many angles to this. In some ways the Fed loses credibility if it doesn’t do something soon as it has been promising to do something for a while. For the last few years I think the Fed has lost some credibility due to the stand-off with this forward guidance nonsense. This is where they identified a point of unemployment, below which they would start tightening. Unemployment fell below that level and they didn’t tighten so forward guidance went out the window. They’ve said rates will be raised by the end of the year, and if they don’t do that – and there’s no obvious reason not to – then they do run the risk of losing a bit of credibility.

If you want to be cynical, over the last few decades you could say they’ve already lost credibility with things like the Greenspan put and the Bernanke put [propping up securities markets by lowering interest rates]. Do you think the Bank of England’s (BoE) forward guidance policy is nonsense too?

Jackson: British policymaking has been in the sin bin at various points over the last three or four decades. The BoE did build up quite a good capital stock through the late 1990s and early 2000s. The labour government seemed to run a pretty good fiscal show but the government itself allowed spending to get out of hand prior to the crisis when they really should have built up surpluses and got the debt lower.

The BoE probably lost a little bit of credibility through the crisis. But it depends what direction you’re coming from. We had never imagined in 2006 we would get policies like quantitative easing, and if you were an old school monetarist you would be horrified by what they’ve done. But markets probably thought they [central bankers] were doing the only thing they could do at the time.

Now with Mark Carney as governor – he’s what I would call a rock n’ roll central banker. He likes the headlines but at the end of the day he’ll follow what the Fed does. When he came over he did forward guidance because the Fed were doing it, and he dropped it very quickly when the Fed dropped it. I think they’ll wait for the Fed to raise rates and they’ll do it shortly thereafter. What’s your outlook in China?

Jackson: Let’s deal with the long term first. I believe five years price targets for the FTSE A50 will be 17,000 and that index is between 9,000 and 10,000 at the moment so that gives a good, chunky rate of return over five years.

But over the short term the credibility has been shot by the government’s reaction to the stock market collapse. It will take a while for confidence to come back and for investors to want to buy in to the market. Obviously you have some taking advantage of cheaper prices but everyone is taking on bigger risk premiums in Chinese equities due to the lack of policy credibility. I think they [the government] should have just let the market find its level. But they didn’t want the market to be falling. It had gone up massively in the run up to that. All those frantic attempts to control the market have made things worse in the eyes of overseas investors and Chinese investors are now a bit wary. However, the medium term potential is actually pretty good. The European Central Bank's QE is supposed to last until next year. Do you think it will have the desired effect before it expires?

Jackson: I think the programme is too big. It was clearly not sized for the market they were buying in so they ran into problems with creating liquidity in certain parts of the market. This is why, at the last meeting, they changed the rules as to how much how much of any country’s debt they were allowed to buy as the programme was too big and they had been running up against the buffers. If they extended it and bought more, they would create a bigger problem.

It’s not that long ago you had ten year bund yields at 5 basispoints and all of a sudden, investors revolted against that. Investors pushed back and yields went back up.

What they could do, if it’s not working, they might go longer than September next year. But for me the Eurozone economy is doing relatively well at the moment and has accelerated quite nicely. It’s not just Germany driving that growth, smaller economies are doing well too - Spain and Ireland are very much at the forefront and there’s a better balance throughout the region. We tend to assume that there will never be any growth in Europe but we are getting decent growth and I suspect that comes partly from pushing own the euro and confidence is coming back. Demand for loans started to increase in 2014 and the ECB got lucky launching QE at that time – that means its programme has an impact but only via a weaker exchange rate and not via pushing supply of credit into an economy where demand for credit is rising. With the anti-austerity programme voted back into power over the weekend in Greece, could that threaten Europe’s growth and stability?

Jackson: Frankly, I think [the Syriza party] it’s a better alternative and is almost a sign of stability. There was a series of negotiations that took place and didn’t go where it was expected to go, but it was finalised in Parliament. At least now they can just get on with it. They have pretty much the same government, so maybe I’m being naïve but hopefully now they can go ahead and implement what’s been discussed over the last few months, instead of putting together a coalition and having that uncertainty hanging over the country.

Rachael Revesz joined in August 2013 as staff writer. Previously an investment reporter at Citywire, she has a background in writing content for retail financial advisors and has covered a wide range of subjects in finance. Revesz studied journalism at PMA Media, which has since merged with the Press Association. She also holds a B.A. in modern languages from Durham University, as well as CF1 and CF2 financial planning certificates from the CII.