Central Bank Tightening: What Consequences for Stocks, Bonds, Real Estate, and Commodities?
The Fed led the way with monetary tightening and now the Northern neighbour Canada has started to follow with a shift in tone and policy. The global economy is finally out of the rut caused by the 2008 shock and the ongoing stagnation and drama in Europe.
After the shock and stagnation of 2008–2012 and some return to recessionary momentum in some countries in 2012, we are now entering a new phase in the global cycle, with modest “reflation” and growth.
The effects of central bank policies on asset prices
I explained in laymen’s terms in another post how to think about the conduct of central bank monetary policy. In short, a central bank tries to keep the economy chugging along at “full potential” while keeping inflation and credit under control. The central bank influences asset prices via various interventions:
- Interest rate policy.
- Communications.
- Asset purchases (“quantitative easing”).
- Direct currency manipulation (rare in Canada and the USA).
When central bank policy rates change, it influences all asset prices because the relative return on assets generally respects one overriding principle: more risk = more return. This means that if the (close to zero-risk) money market rates change, riskier asset market prices change as well. To get better returns in stocks or bonds, prices must DROP, because then buying at those lower “bargain prices” allows to extract more potential long run return from the same assets. Although it is a bit more complex than this for reasons beyond the scope of this post, it generally holds that higher interest rates tend to keep asset prices lower in stocks and bonds.
As for communications, these have a direct impact on expectations, which in turn influence current demand and supply conditions in various markets. Suppose a central bank suggests it will increase its policy rate in the future, what will markets do? This means markets expect asset prices in stocks and bonds to DROP or to be generally lower than they otherwise would have been… what would you do if you had lots of stocks and bonds and you expected these to take a hit on their market value? You would sell them off, right? Well, this happens indeed — expected future higher money market rates put downward pressure on current asset prices via this effect, so higher central bank rates puts a break on stock and bond prices, as well as other financial asset prices.
Asset purchases do the same thing and are easy to understand: suppose the central bank is buying lots of bonds now and stops buying them suddenly… this decreases demand for bonds and decreases available liquidity in the money market: when the central bank buys assets like bonds, CDOs, and stock indices, it pays with “liquidity”, which then floats around in financial markets and makes credit cheaper and easier to roll over. When this policy stops or the pace of buying slows, you get the reverse effect, again with the “expectations effect” coming into play, as explained above: other big market players expect lower prices and don’t want to hold assets with falling prices, so they sell as well and this adds to the downward price spiral.
Although direct currency manipulation is rare in North America and Europe, others do it massively, and, more importantly, even the other policies explained here still impact the currency: when interest rates drop, money market deposits have lower yields, which makes domestic assets less attractive to global players and this creates a drop in the value of the currency due to a drop in global demand for domestic money market assets. When interest rates tend to rise, you get the reverse effect and the currency tends to appreciate (or depreciate less than it otherwise would have).
Where are the Fed and the Bank of Canada going with their policy rates and policies?
Not far!
The Fed has already done “a lot” of tightening relative to all other major economies and all that tightening has been “priced in” by markets: the USD generally appreciated in 2 phases: the first phase in 2014–2015, when it started suggesting an end of QE expansion and a gradual and slow return to a normal policy stance, the second phase in late 2016 when it started to tighten and Trump’s yet-to-be-seen fiscal changes and mega infrastructure programs were priced into expectations. This can be seen with the USD effective exchange rate:
The Fed tightening and the Trump expansion were “over priced in” and the USD has thus been losing steam since January, as inflation has remained subdued, Trump policies are falling far short of expectations, and no “overheating” seems to pose a direct menace to financial stability down the road, as can be seen by the total inflation rate (core PCE inflation sends the same message):
For Canada it was the exact opposite: the oil price drop (in part caused by 2014–2015 USD appreciation) and fires in oil production regions created a mini recession, which caused the Bank of Canada to decrease the policy rate in 2015 to help boost activity so as to get out of that mini recession as quickly as possible:
But recent data suggests the soft patch is over and that Canada is on “OK footing” for growth going forward, thus warranting a change of policy by the Bank of Canada, which came somewhat quickly relative to what markets are accustomed to for central bank “forward guidance”: nowadays, central banks that want to start increasing rates go about it veeeery slowly and gradually, they use a “policy announcement date” to first “warn markets” that rate hikes are coming, without changing the rate, THEN at the next meeting they actually move ahead with a rate hike, which by then is totally priced in. Central banks do this to help markets prepare for the change by changing their portfolio allocations and hedging their balance sheets with various futures and options trading positions (this is beyond the scope of this text, but I may try to make this simple to grasp for you in a post some time later).
The policy rate, mortgage rates, and all that
When the short term interest rate increases, it puts upward pressure on ALL other credit market rates, including long term rates like mortgages, which make people jittery about their variable rate mortgage or their upcoming mortgage renewal, for example.
Don’t panic. The ONLY thing that creates a significant rise of interest rates is current and future inflation (for reasons I might explain some other time — just trust me for now). Inflation in major economies can cause inflation in others via various complex channels, so you have to look at both domestic and global inflation, especially in the larger economic zones such as the USA, the Euro Area, Japan, and China.
Where is inflation now in the major economies?
Core inflation rates send essentially the same signal. Everybody (expect the UK, which is a special case due to past GBP depreciation) is significantly below 2% and inflation is not menacing at all to bust above target in a surprise move. There is a “temporary effect” due to falling oil prices, but still, I do not see “clear” inflation pressure that would cause significantly higher rates quickly.
Central banks are thus moving SLOW AND GRADUAL on their policy stance, mostly to move their rates further from zero to be able to cut later and also to knock off a bit of excess credit and asset speculation to avoid a problem down the road… but not much more than that!
As long as inflation does not creep significantly higher and clearly above 2% on a sustained basis, do not expect ”lots” of monetary tightening, hence do not expect any major asset or credit market shock, so stocks seem to be in a flat mode, with neither upward nor downward pressure, as is the case for bonds, unless another relapse of the US debt ceiling recurring saga causes a “mini bond market trauma” in the Fall.
Real Estate, commodities, and markets
Given that interest rate hikes will be modest and QE “tapering” (slowing of asset purchases and gradual selloff of central bank assets) will be slow and gradual in the USA and other major economies, there is no fear of a big “negative turnaround” in the global economy, financial markets, real estate, or commodities.
The global economy going forward will run mostly on “fundamental demand” driven by jobs, income, and expanding markets, and less macro policy such as monetary or fiscal policies, which seem to be moving to the sidelines in a slow and gradual “wait and see” mode.
Since real estate is driven by factors such as demographics, disposable income, interest rates, liquidity, and (more and more) global wealth looking for somewhere to “park”, I do not see any shocks in this market over the 12–24 month horizon.
Canada does have highly leveraged households, so any significant rise in mortgage rates could cause some difficulties in the refinancing and a slowdown in real estate and the overall economy, but the probability of a big rise of mortgage rates is low for now and for the next year specifically due to this context: a highly leveraged economy is sensitive to interest rate shocks, so this keeps interest rates low AND prevents additional credit expansion because credit creation, money creation, and inflation are all inter connected, as I explained in a previous post.
For Canada, a rise of 1 percentage point in the average mortgage rate could increase mortgage payments by 10%, thus squeezing households that need to refinance and also those on a variable rate mortgage.
For example, a 300k monthly payment mortgage at 5% fixed rate on a 25 year period is roughly 1744$ per month, while the same mortgage setup will cost 1919$ per month if the mortgage rate is 6%, which is 175$ per month more, or 10% more. Not insignificant, but still not “crisis level” setups and this is a “worst case” scenario based on a theoretical setup that is not realistic: most mortgages are not at 300k outstanding, not all mortgages are renewed each year, and mortgage rates may not rise all that much in the next 2 years… so everybody chill!
Commodity prices are driven by global supply and demand, speculation, and by policies of the major central banks, because liquidity conditions influence inventory costs and management and futures market positions, so they have an impact on oil and other commodities. Most of the USD appreciation (and its deflationary effect on commodities) has worked its way through commodities, but that does not fix things like oversupply and other aspects of the global commodity market, so although commodities had the global monetary shock and were thus held down, they still have to work through “real supply and demand” conditions, which seem to disfavour any big upward momentum going forward. Click the heart to show appreciation…
Pascal Bedard
