We re­visit the topic of liq­uid­ity to see if cen­tral bank pol­icy is in­flu­enc­ing mar­ket volatil­ity

Shares - - CONTENTS - By Russ Mould, in­vest­ment di­rec­tor, AJ Bell

What would make the Fed­eral Re­serve change tack?

Reg­u­lar read­ers could be for­given that this col­umn is ob­sessed with the is­sue of liq­uid­ity, not least be­cause that is the case. We have al­ready looked at how cen­tral banks are drain­ing it away and how is­sues such as cap­i­tal con­trols could mean that in­vestors must never as­sume that it will al­ways be easy to buy or sell as­sets, owned di­rectly or indi­rectly via funds, when, in the size and at the price they want.

Now we must re­turn to the is­sue of cen­tral bank pol­icy be­cause our warn­ing that higher rates and less quan­ti­ta­tive eas­ing (QE) could pro­voke in­creased volatil­ity does not seem too far off the mark, given the au­tumn stock mar­ket wob­ble.

The Fed has now re­duced its bal­ance sheet by some $351bn, or 8%, while the S&P 500 is some 7% off its all-time high.

This may be just a co­in­ci­dence but it is enough to prompt com­plaints from no less than US Pres­i­dent Don­ald Trump, whose will­ing­ness to mea­sure his ad­min­is­tra­tion’s suc­cess by how high the US stock mar­ket goes may yet prove a poor choice of yard­stick.

The Pres­i­dent’s colour­ful ac­cu­sa­tions that his coun­try’s cen­tral bankers are ‘loco’ and ‘go­ing crazy’ ar­tic­u­late a deep-rooted fear in the mar­kets that higher rates and less stim­u­lus could mean lower share prices.

The Fed does not seem moved by such talk as yet, but this does beg the ques­tion of what might have to hap­pen for the US cen­tral bank to stop tight­en­ing and start loos­en­ing pol­icy once more.


Fed chair­man Jay Pow­ell’s pre­de­ces­sors Ben Ber­nanke and Janet Yellen over­saw the launch of all three phases of the Fed’s QE scheme in Novem­ber 2008, Novem­ber 2010 and Septem­ber 2012.

All three of those pro­grammes came in the wake of a com­bi­na­tion of stock mar­ket weak­ness, a sell­off in high yield (junk) bonds and a flat­ten­ing in the yield curve (a de­cline in the premium yield of­fered by US 10-year Trea­suries rel­a­tive to two-year ones).

Pow­ell seems to have a dif­fer­ent out­look, given his 2017 quote that ‘it’s not the Fed’s job to stop

peo­ple los­ing money’ and the US cen­tral bank’s re­cent sug­ges­tions that the yield curve is not as re­li­able an in­di­ca­tor as it once was.

If fi­nan­cial mar­ket in­di­ca­tors will not sway Pow­ell and col­leagues, then per­haps we have to look to real-world, eco­nomic ones.


This col­umn has looked at US data to see which items may have in­flu­enced Fed think­ing un­der Ber­nanke and Yellen.

Of the real-world ones, three ar­eas seem to have tempted the US cen­tral bank to pull the mon­e­tary stim­u­lus trig­ger in the past (the rings show when QE1, QE2 and QE3 were launched):

• Weak­ness in the In­sti­tute for Sup­ply Man­age­ment’s (ISM) man­u­fac­tur­ing pur­chas­ing man­agers’ in­dex (PMI)

• Weak­ness in the non-farm pay­roll data and a loss of mo­men­tum in job cre­ation

• A slack­en­ing in the rate of in­fla­tion

The fol­low­ing charts il­lus­trate these points, with the rings high­light­ing when each phase of QE came into ef­fect.

The Fed has a twin man­date of em­ploy­ment and in­fla­tion. The lat­ter has ebbed a lit­tle and the PMI has pulled back slightly from its peak but nei­ther re­ally has done so to the de­gree seen ahead of QE2 or QE3.

More­over, US job cre­ation is still strong, judg­ing by the 250,000 new non-farm pay­rolls added in Oc­to­ber and 3.1% wage growth.

Un­der such cir­cum­stances, the Fed seems un­likely to be de­flected off course by in­creased as­set price volatil­ity. Fi­nan­cial mar­kets are on their own.

In­vestors must de­cide whether mo­men­tum in earn­ings, cash flow and div­i­dends are suf­fi­cient to jus­tify pre­vail­ing val­u­a­tions and com­pen­sate them for the spe­cific risks that come with in­di­vid­ual as­set classes and geo­graphic re­gions, be­cause there is no longer enough cheap money around to lift all prices on a tide of liq­uid­ity.

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