Since the global financial crisis, market players have worshiped at the altar of G7 central banks, with bond and equity markets placing faith in the global monetary doctrine of low interest rates and cheap liquidity. Put crudely, in the post-Lehman world order, the central-bank backed capitalism of the west has matched the state-backed capitalism of the east, arguably both in scale and ideology.
“Central bank policy over the last three years has been the main driver of financial market performance,” says Lars Kreckel, equity strategist at Legal & General Investment Management (LGIM).
Since the US Federal Reserve cut its target interest rate to an historic low of 0% to 0.25% in December 2008, 13 other central banks have followed its lead in running a zero interest rate policy (ZIRP).
According to one estimate, those 14 economies are host to a combined equity and bond market capitalization of $65 trillion. That is a lot of money searching for a yield above the effective nominal policy rate of near-0%.
Meanwhile, central banks in the US, Japan and UK have injected hundreds of billions of pounds of liquidity through quantitative easing (QE), while the European Central Bank (ECB) has said it stands ready to intervene. The Fed alone has grown its Treasury holdings to an all-time high of $2.9 trillion since the programme began in December 2008.
Andrew Milligan, head of global strategy at Standard Life Investments, sums up G7 central banks’ market impact as “extremely important for government bonds, relatively important for credit and somewhat important for global equities”.
Rock-bottom interest rates have sent government bond yields down and prices – which move in the opposite direction – soaring. As those yields collapsed, investors moved into corporate bonds in search of yield, pushing their prices up too.
While equities have had a rough ride during the crisis, they would have suffered even more without the extraordinary support. “G7 central bank policymaking has cut off the tail risks of a 1930s-style depression and a collapse of the euro,” says Milligan.
While some members of the Fed have talked about slowing QE this year, there is little sign of any moves by the Bank of England or Japan or by the ECB.
Peter Hensman, global strategist at Newton, the asset manager subsidiary of BNY Mellon Asset Management, says policy easing has pushed risk asset prices higher.
“It is intriguing to see official unease at the re-emergence of the ‘hunt for yield’, the more unsettling description of the very transmission channel through which it is hoped ZIRP and QE will operate.”
On top of this come signs that central banks are moving away from strict inflation targeting. The incoming governor of the Bank of England, Canadian Mark Carney, has raised the idea of targeting nominal GDP (NGDP) – a combination of inflation and economic output.
Speaking at the World Economic Forum in Davos, he said central bankers should be prepared to take “unconventional” measures to help economies achieve what he called “escape velocity”.
LGIM’s Kreckel says NGDP would probably help equities outperform bonds, as it would add to fears of inflation further down the line that could force yields up and prices down.
“It will be marginally positive for equities,” he says. “When I do earnings forecasts, my starting point is to look at NGDP growth as that’s a good guide to volumes for companies.”
Looking forward, the picture is more clouded. Bill Gross, managing director of Pimco, the world’s largest bond fund, says ZIRP and QE are “increasingly ineffective because we’ve gone about as far as we can go”. “The world is attempting to get out of the burden of deflation and high debt levels,” he said last month.
Newton’s Hensman echoes that view, saying he doubts the asset market impact of ZIRP and QE will cause the “self-sustaining growth cycle that policymakers would like”.
He adds: “Policies that drag future activity into the present and raise current equity valuations should dampen – not increase – the longer-term returns investors anticipate from equities.”
Milligan says that in a world of “lower for longer” interest rates, “yield compression can continue for much longer than many commentators expect, as events in Japan clearly demonstrate”.
As long as ZIRP stays in place – and Milligan sees no rate rises until 2016 – the current trend will stay in place.
Ewen Cameron Watt, chief investment strategist of BlackRock Investment Institute, says government policy is helping equities. “That is why we had this big rally in risky assets over the last three months but it will continue to help,” he says.
Kreckel says he doubts there will be a “great rotation” between bonds and equities in that situation, although equities “stand to gain more than bonds”.
One impact could be a steepening of the yield curve as investors start to price in the danger of inflation further out.
Kevin Arenson, chief investment officer of Stenham Asset Management, does not foresee an end to the search for yield but adds: “The asset classes where yield is found may shift, potentially from fixed income to equities.”
In the meantime, the big risk is that growth or inflation return quicker than expected and rates rise suddenly.
Hung Tran, senior director of capital markets at the Institute of International Finance, warns of a “potential under-pricing of credit risk”. “An end to continued liquidity provision by central banks may trigger some reaction in the market place,” he says.