Today’s market commentary seems obsessed with central bank policy. However, while the policy and interest rate regimes are critical considerations for investors, often too much attention is paid to short-term minutiae at the expense of the bigger picture.
While the investment industry dedicates huge amounts of resources to analysing 0.25 per cent changes in policy rates and whether or not the word “considerable” crops up in the minutes of the Federal Reserve, views on long-term structural trends and potential turning points are often left to subconscious rules of thumb that can reveal behavioural biases and other inconsistencies.
Last month’s policy announcement from the Bank of England is therefore far less important with regards to the change in the interest rate itself than in what else it can tell us about the prevailing policy mind-set, and how this interacts with market perceptions of risk.
Bank of England policy: More of the same, or a sign of transition?
Since the financial crisis, policy makers in most major economies have responded to weak growth with ever lower rates or further bond buying. This course of action has contributed to the strong performance of bonds, or bond-like assets – and has influenced investor perceptions of their “safe-haven” qualities.
As the Bank of England chose to lower rates, last month’s action could be seen as more of the same. But this would be to ignore the broader context, the other actions announced, and the language of Mark Carney.
It is not a new argument that cutting interest rates appears to have become less and less effective in boosting growth, but other actions taken by the Bank of England last month suggest that they acknowledge that something new is required.
In this regard the cut in base rates and the new QE programme may be a sideshow, while the new Term Funding Scheme (TFS) could be extremely important. TFS represents an explicit attempt to ensure that policy actions translate to real effects on households and companies.
A shift in the policy stance in the UK and around the world could be very meaningful. It could challenge those rules of thumb about which assets are safe and which are risky, how to add diversification to a portfolio, and what exactly it is we mean when we say an asset is “cheap” or “expensive”.
Interest rates and investor experience
The past matters in financial markets: investors fall in and out of love with assets based on past returns, risk models look at past behaviour and predict what will be risky or safe in the future, regulators fight yesterday’s battles.
It is no surprise then that, given the experience of the last 30 years, fixed-income assets are considered “safe” and equity assets “risky”. Not only have fixed-income assets shown themselves to be safe while generating returns that one would normally associate with growth assets, but the experiences of the tech bubble and financial crisis mean that demand for protection against drawdown is arguably higher than ever.
