When sizing up central bank stimulus, you might be short-changing their efforts if you focus only on the Federal Reserve. Michael Hartnett, chief investment strategist at Bank of America, has taken a global perspective on efforts to revive the economy over the past five-or-so years, and the numbers are ... big.
Consider: The five biggest central banks have purchased a combined $12-trillion (U.S.) in financial assets; there have been 520 interest rate cuts; and government bond yields have fallen to their lowest levels in 220 years. The market impact has also been massive. The global equity market cap has doubled from its 2009 low, to a high of $58-trillion in May.
Of course, these big numbers are causing no amount of fretting among investors now that the Fed has signalled it could start to unwind its bond-buying program, also known as quantitative easing or QE, later this year. The yield on the 10-year U.S. Treasury bond rose as high as 2.6 per cent earlier this week, up a full percentage point since May.
According to Mr. Hartnett, Treasury bonds are now on track for their worst year of returns since 1978. He also pointed out that investors are withdrawing money from fixed income funds at a brisk clip, with outflows this week alone on track for a record $20-billion.
Despite the market convulsions, he remains upbeat that it will all mean good things for stocks, as money flows out of bonds in a “Great Rotation.”
“But the end of the greatest bond market in history and the 4th great secular turning point in bond yields in the past 100 years was never going to be a quiet event,” he warned in a note.
Indeed, he outlined two big risks this summer. One, a market event, where a large hedge fund blows up or an emerging market central banks run into trouble, leading to a knock-on effect where investors flee risky assets. Two, a macro event, where rising rates hit the U.S. housing recovery. Despite the risks, he believes it is best to stay bullish on stocks and can see an equity bounce ahead.
“New equity highs require higher rates to cause stronger economic growth (bank stocks are the best barometer of macro rehabilitation),” Mr. Hartnett said in his note. “In our view the ultimate macro ‘pain trade’ must be that Bernanke has not made a policy mistake but rather is ‘rotating’ away from Wall Street to Main Street via interest rate expectations. Higher rates and higher bank stocks would confirm this.”
Here’s a contrarian thought, though. What if central bank plans are far different from central bank reality – that the idea of withdrawing stimulus meets the brutal fact that the economy can’t withstand it? Recall that the Bank of Canada warned some time ago that it intended to raise its key interest rate, only to leave its rate unchanged at 1.25 per cent for going on three years.
In this sort of environment, it would make sense to pounce on interest-rate sensitive investments – including dividend payers and real estate investment trusts – as they sell off. If everyone is convinced that rates will rise and the bull market in bonds is over, doesn’t that imply the trade is done?
Douglas Porter and Robert Kavcic at BMO Nesbitt Burns argued in a note that the spike in bond yields could be getting ahead of itself, given that core inflation is low, the Fed’s key interest rate is still at zero and the global economy is struggling. Nonetheless, they believe long-term interest rates are headed higher over the next 18 months.
“We believe that the rate backup will be driven by the ongoing recovery in the U.S. economy, most notably in housing, rather than imperil the recovery,” they said.