It’s no news to anyone that we are living in a historically weird time for monetary policy. Interest rates have been kept exceptionally low for over a decade since the global financial crisis, there are trillions of dollars of bonds with negative yields in the market and the Federal Reserve has recently begun cutting rates again, just a few years after embarking on a hiking cycle. This raises the question: Just how effective is modern central bank policy? This note from Morgan Stanley MS Chief Cross-Asset Strategist Andrew Sheets attempts to answer the question.
Slowing growth, lower rates
What can central banks do to combat slowing growth, and what are the consequences of these actions? The European Central Bank is widely believed to be about to further cut rates by 10 basis points in September, and the Federal Reserve is expected to follow suit a week later with a 25 basis-point cut. The conventional wisdom is that such actions will be beneficial for equity prices. The note’s author disagreed:
“Lower interest rates, which have pushed bond yields down, have been widely cited as a supportive factor for stock markets, making stocks look cheaper by comparison to richer bonds. But we are more skeptical. Both of these central bank actions are widely expected, potentially limiting their ability to have an additional positive impact. And the magnitudes involved are modest - are companies and consumers in Europe really going to change their behaviour for a tenth of one percent change in the interest rate?”
History can be instructive. In the past, when monetary policymakers have lowered rates during periods of slowing growth, it was commonly interpreted as a signal of low confidence in the market. The first rate cut implemented after a hiking cycle has halted is similarly usually a marker of a downturn. Sheets said that consumers will see these actions as bearish, and will act accordingly:
“Actions by central banks are often portrayed as a free lunch. We disagree. Rate cuts can have a negative impact on confidence, as consumers start to worry about exact why their central bank feels it’s necessary to take action. In the most recent University of Michigan survey of consumer confidence, many cited the Fed’s decision to cut rates in July as something that made them more concerned about the economy going forward.”
The note went on to discuss the effect that lower rates have on the banking system, citing the poor stock performance of European banks as evidence that low rates are detrimental to lenders. It is true that banks struggle in a low-rate environment -- by decreasing the amount of money that it can earn on their loans, a bank’s net interest margin shrinks, which decreases profitability for shareholders.
Morgan Stanley is advising clients and outside investors to remain defensively positioned in their portfolios, in anticipation of a potential market turn that could be caused by the very actions being taken to prevent it.
Disclosure: The author owns no stocks mentioned.
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