The Central Bank Effect

As 2018 ended, it appeared as if the Federal Reserve was intent on further interest rate hikes (after 4 in 2018).  In addition to interest rate hikes, the Fed had hinted that the reduction in its balance sheet would continue, and was basically on “auto-pilot”.  Both of these policies made investors fearful that the Fed would over-tighten monetary policy and cause the economy to contract sharply, with a distinct possibility of recession.

This year, one of the reasons the market reacted so strongly to the January Fed meeting was the abrupt pivot that the Fed signaled with respect to rate hikes.  In a fairly dramatic change of tone, the Fed indicated in January that further rate hikes were “on hold”, and that at current levels the fed funds rate was nearing their “neutral” target (whereby monetary policy is balanced).

Remember the old adage ‘Don’t fight the Fed’?  Well it works in both directions when it comes to markets.  The saying came about to warn investors that when the Fed was hiking interest rates to slow an overheating economy, investors would be wise to take note.  Conversely, if the Fed wants to lend support to the markets – even though they would never admit this intention – they can loosen monetary policy and add liquidity to the financial system.

While the double pause in rate hikes and balance sheet reductions isn’t a direct loosening of monetary policy, it certainly was a signal to the market that the Fed is aware of the damage the 4Q18 stock plunge could have on the economy.  Moreover, it is a signal that the Fed won’t be obtuse to market signals and that the pause in rate hikes should help foster an environment where the economy and the markets face reduced headwinds from central bank policy.

While the U.S. central bank has often been first to act, the Chinese central bank began its most recent stimulus campaign last year.  The PBOC in China cut the reserve requirement for banks five times in the last 12 months.  It further injected liquidity directly into the financial system via the central bank’s open market operations.  Additionally, it lifted restrictions on real estate investing to help support property prices and keep one of the world’s largest asset bubbles from bursting.

China’s stimulus, as a measure of its GDP, has been quite large – and judging by the reaction in its markets (see below) quite effective as well.  With China injecting massive liquidity into its markets and economy, its natural to see an economic rebound and asset price inflation.  The question some will ask is what happens when the stimulus runs its course?  But that is a question for another day.

In addition to the Fed and the Chinese central bank using monetary policy to stimulate their economy and markets, the ECB in Europe has also done some heavy lifting.  Europe has been experiencing an economic slowdown.  In 2016 & 2017, the ECB gave its member banks low interest loans to help spur lending.  Since these loans were set to mature soon, the ECB this year decided to refinance those bank loans to ease concerns of a credit crunch once the olds loans came due.

So what we have seen in recent months is a myriad of central banks around the globe loosening monetary policy and providing further liquidity to the financial system, which in turn has boosted asset prices, consumer and investor confidence, and a spate of economic data.

In China – the world’s second largest economy – we’ve seen GDP growth pickup a bit, while retail sales, industrial production, and the much-watched export data experience significant accelerations in growth rates.  This has had a positive spillover effect on countries that do business with China, as well as most of the Asian economies.

In the U.S, we have also seen economic data improve, albeit from fairly depressed levels at the end of 2018.  Jobless claims recently hit their lowest levels since 1969.  The index of Leading Economic Indicators has bounced recently, and the chart below shows the recent sharp, upward revisions to Q1 2019 GDP forecasts by the Atlanta Fed.

All of the above factor into the sharp bounce in the equity markets this year.  Coming into the year, investors were positioned for more Fed rate hikes, a slowing economy, and downward revisions to earnings estimates.  As those assumptions failed to come to fruition, global investors found themselves underinvested in equities and too defensively positioned to participate in the stock rally.

In the short- to intermediate-term, how portfolio managers are positioned can have a big effect on market direction.  To wit, in February CFTC futures data showed record short positions in S&P 500 futures contracts.  As markets marched higher, a rush to cover these losing bets only added fuel to the fire.  And in March the BAML global fund manager survey showed fund managers had their lowest allocations to equities since September 2016.  These managers know it is okay to be wrong in the short-term, but to stay wrong would be compounding market risk with career risk.

In all, we feel that this combination of circumstances of underinvested participants and global central banks pumping the liquidity spigot should continue to be supportive to the markets for the time being.  But we remain mindful of the fact that we are very late cycle in this economic expansion, and even global central bank planning cannot stave off the reality of economic gravity forever.

Jordan L. Kahn, CFA

Chief Investment Officer

Sources:; Seeking Alpha; Raymond James;; Standard & Poors; Barron’s; Charles Schwab;

*This Market Monitor is provided for informational purposes only and should not be interpreted as investment advice.