Since the 2008 financial crisis, we have witnessed nearly a decade of policy experimentation from the U.S. Federal Reserve. The most noteworthy of these policy experimentations has been known as quantitative easing, which was a strategy to purchase vast quantities of government bonds and mortgage-backed securities in an effort to keep interest rates low (and stimulate the economy). That rescue has worked to a large degree, but it has also bloated the Fed’s balance sheet to an unheard-of $4.5 trillion.
One fundamental rule that Pinnacle Trust has adhered to during this time-period is that we “don’t fight the Fed”. The academic logic behind not fighting the Fed is centered on the idea that there exists an inverse relationship between interest rates and stock valuations. Therefore, when the U.S. Federal Reserve is actively purchasing bonds in the open market, there will be downward pressure on interest rates and upward pressure on equity valuations (which become cheaper from the “relative standpoint” that there are no good alternatives).
Has this strategy worked? Between February 2011 and October 2015, the Fed’s quantitative easing strategy pushed the U.S. 10-year treasury downward from 3.75% to 1.99%. During this time, the S&P 500 index soared from 1100 to 2050 in value as the Forward Price/Earnings ratio increased from 12.5x to 16.5x. The academic logic worked perfectly as stock prices appreciated due to valuations increasing (not true earnings growth). The decision not to fight the Fed has kept our clients in the equity markets during a time-period where we have had unfavorable views on equity fundamentals.
However, with the U.S. and Global economies stabilizing, the Fed announced last week that it will begin slowly unwinding this historic quantitative easing strategy by selling these same government bonds and mortgage-backed securities back into the open market. This announcement has caused many investors to speculate as to whether or not this decision will cause a significant rise in interest rates and subsequently a reduction in equity valuations. We do not believe so.
There are two key reasons we do not believe that the unwinding of the Fed’s $4.5 trillion balance sheet will have a reverse impact:
- The Fed is still in control….If the unwinding pressure causes a larger than expected increase to interest rates or disruption to equity markets, they can simply slow down or even halt. Many economists anticipate that the Fed will never truly unwind the balance sheet to normal levels because the Fed and U.S. Government have realized that there are many benefits to the larger balance sheet, such as reducing their own interest payments in a time of high debt.
- Second (and more importantly), the U.S. Federal Reserve is not the only central bank that matters. The European Central Bank and Bank of Japan are still employing their own version of quantitative easing and may continue for some time. It is very important to understand why this matters:
Currently, 10-year government bonds in major developed markets are as follows:
U.S. 10-Year: 2.25%
German 10-Year: 0.45%
U.K. 10-Year: 1.35%
Japan 10-Year: 0.027%
* To put this in perspective, the 10-Year U.S. Treasury is currently yielding more than many 10-Year European High Yield Corporate Bonds.
With many sovereign wealth funds required to hold high-grade credit, U.S. treasuries are the clear risk/return choice within the developed economies. This, coupled with the fact that the European Central Bank and Bank of Japan are still actively purchasing bonds in the open market, means that there will continue to be significant demand for U.S. government bonds and mortgage-backed securities; thus continuing the downward pressure on interest rates.
While the thought of rapidly rising interest rates is daunting for a number of reasons, it is an unlikely scenario given that interest rates are anchored by easy money efforts around the world. As a result, we are adapting our fundamental rule from “Don’t Fight the Fed” to “Don’t Fight the World Central Banks”.
As always, we continue to monitor.
Reid Davis serves as Chief Investment Officer at Pinnacle Trust. You can reach him by emailing him at [email protected] or by calling the office at 601-957-0323.