In recent months, we’ve witnessed a huge stand-off between the bond markets and equity markets.
Buoyed by hopes of an economic recovery, equity enthusiasts stepped up their purchases, helping US share markets to enjoy their best month in a year in July. At the same time, investors with a gloomier predisposition were piling into bonds, pushing their yields to near historic lows.
But recently, share investors have seemed to blink. As Bill Hester, a senior analyst at Hussman Funds Management notes, they’ve “began to appreciate the concerns of bond investors, including weak trends in the leading indicators, in the jobs data, in components of the GDP data, and in the slowing rate of inflation among various price indexes”.
Hester points to a recent paper by James Bullard, the head of the Federal Reserve Bank of St Louis, who sits on the US Federal Reserve’s monetary policy committee.
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Bullard argues that when inflation and interest rates are at extremely low levels, conventional monetary policy becomes ineffective. Central banks aren’t able to cut interest rates to stimulate the economy because interest rates can’t be reduced below zero. And the markets know that interest rates won’t be increased if inflation does rise, because inflation levels are still too low.
As Hester notes: “In effect, Bullard is saying that a policy that makes a promise to investors that rates will stay low for long periods of time backfires. While the Fed may intend to fan inflation concerns in order to motivate aggregate demand, the private sector begins to assume a semi-permanent state of very little change in inflation, and a growing inability for the Federal Reserve to do anything about it.”
The problem is that sharemarket investors have now been conditioned to show an unwavering faith in the Fed’s ability to solve problems. They still believe that Fed is engaged in active monetary policy (such as setting official interest rates, or quantitative easing), and that monetary policy will play an important role in the recovery.
“This faith in the Fed that investors have, although unquantifiable, has certainly played an important role in the performance of stock markets over the last few years. After more than a decade of Greenspan’s Put, and Bernanke’s do-whatever-it-takes attitude in protecting investors from taking appropriate losses, investors have been conditioned to believe that the Fed has their back.”
This unswerving faith in the Fed, “also must be playing a role in the valuation of the stock market, considering that investors are pricing stocks nearly 40% above long-term valuation levels (using normalised earnings) during an economic recovery that is by almost any measure lagging far behind the typical post war recovery”.
But what if Bullard is right? What is the Fed’s promise to keep interest rates low for a long period of time ultimately means that the Fed is powerless to live up to the expectations of share market investors?
Hester argues that deflation and disinflation come in different forms. There is good deflation when prices fall due to a capital investment boom that improves productivity and economic efficiency. For instance, the construction of the national railroad system in the US meant that goods could be moved around the country more efficiently. This pushed down commodity prices, and contributed to widespread deflation during the second half of the 19th century. Similarly, he notes that prices also fell in the 1950s, but the price declines were shallow and short-lived, and the underlying economy was unaffected.
But there’s also a more damaging form of deflation that results from a fall in aggregate demand. This “pinches corporate profits, and then wages, which can create a feed-back loop, sending prices lower again”. This was the deflation that the US experienced in the 1930s, and which has gripped Japan since the mid 1990s.
But because deflation comes in different forms, the reaction of share markets to periods of falling prices also differs. Hester notes that “stock returns were positive but below average in the second half of the 19th century during periods of deflation. The deflation of the 1930’s coincided with losses on average for investors”.
Hester says that based on Japan’s experience, there’s also likely to be a change in the dynamic between how interest rates affect the share market. Typically, falling interest rates support stock prices because they usually point to an easing of inflation concerns. As a result, bond yields and stock prices typically move in opposite directions.
This was the usual relationship between stock prices in Japan and government bond yields right up to the time when the country’s stock and real estate bubbles burst. But as deflation took hold, relationship reversed. According to Hester, when an economy becomes mired in a low growth, deflationary state, falling interest rates “imply an expectation of deflation and economic weakness, and become associated with weaker stock prices”.
Hester notes that before Japan became gripped by deflation, periods of falling interest rates were associated with an average annualised stock return of 23% (as he notes, this period does include a stock market bubble). But when rates were rising, the stock market fell on average by 4%.
Since 1995, however, periods of falling interest rates have been associated with drops in the share market of 12%. In contrast, when interest rates were rising, stocks climbed by 11% on average. As Hester notes, when interest rates are close to zero, “investors become optimistic about the possibility that prices will rise because market participants have come to expect continued deflation”.
The other indicator that breaks down when interest rates are held close to zero for a long time is the slope of the yield curve. Typically investors wait until the yield curve is inverted (where short-term interest rates are higher than long-term rates) to signal that a recession is approaching, and that it’s time to become defensive in their stock portfolios.
But, in a low growth, deflationary world, “that signal might never come”. Hester says that for two decades after the 1929 crash, short-term and long-term interest rates stayed at very low levels and “the yield curve was unhelpful in forecasting recessions”. It only managed to improve its record when yields normalised back towards their longer-term levels.
The Japanese experience is very similar. Before 1995, the Japanese yield curve had a strong track record in predicting recessions, or indicating that the economy had just entered into a recession. Post-1995, when deflation started showing up in the country’s price measures, the track record of the yield curve started deteriorating. “It hasn’t forecasted any of the three recessions that have occurred since the 1990s.”
Hester argues that the longer Japan kept its official interest rates low, and continued to promise low rates, “the more persistent and intractable the pattern of deflation has become in Japan.” In the US, he says, the risk is not only the damaging effects on the economy. There’s the added risk to share markets if investors lose their faith in the Fed.