Bernanke hints at earlier monetary policy change
Ben Bernanke's decision this month to tell the world US interest rates would remain near zero until unemployment fell below 6.5 per cent is possibly the most pivotal comment for sharemarket investors in four years.
24 Dec 2012 SYDNEY MORNING HERALD - MATTHEW KIDMAN
It was the first tangible sign the Federal Reserve is beginning to turn its mind to reversing the ultra-accommodative monetary policy that has been in place since the global financial crisis brought the world economy to its knees. It would be negligent for investors to ignore these comments given loose monetary policy has been the jet engine driving share prices in that time. While the fiscal cliff and US debt ceiling will preoccupy our thoughts over the holiday season, monetary policy will rapidly move back to centre stage.
Previously, Bernanke, the Fed chairman, pictured, had stated short-term rates in the US would remain at or near zero for an extended period. This had been interpreted to mean until 2015. In addition Bernanke has implemented money printing exercises in which the Fed is buying $85 billion of government and mortgage backed securities every month. All this has allowed sharemarket investors to operate in a blissful state with no short-term monetary policy shocks on the horizon to derail the near four-year upward charge.
All of a sudden Bernanke's comments have thrown out the old play book. He knows the biggest challenge the Fed faces since the 2008 financial crisis is how it untangles its unprecedented involvement in markets without causing havoc. With no blueprint it will mainly be guesswork. The Fed has bought trillions of dollars of government securities and put its heavy foot on interest rates.
By announcing 6.5 per cent unemployment as the trigger for policy change Bernanke has softened the market up and given the Fed far greater flexibility to make its move. Many commentators have suggested the target of 6.5 per cent unemployment won't be achieved in the US until the middle of 2015, meaning status quo. What if, however, the US economy gathers a head of steam during 2013 and employment starts to grow strongly? Under this scenario the Fed could move on monetary policy well before most experts currently believe. Alternatively, if employment growth continues at the same rate as 2012, with population increases, unemployment might not breach 6.5 per cent until 2017.
For the moment let's concentrate on a pick-up in economic activity in which unemployment falls from the current level of 7.7 per cent to 6.5 per cent by the end of 2013. Bond investors in the US won't wait until Bernanke makes his move. They will pre-empt this and start to sell bonds, forcing yields to rise. A very strong economy would cause investors to move aggressively, forcing equity investors out of their malaise. It could even mark the end of a 30-year bull market in bonds.
Sharemarket bulls will preach that equity prices will continue to rise under these circumstances because strong economic growth means robust corporate profits. The evidence of this though is scarce. In 1994 when then Fed chairman Alan Greenspan caught the market off guard by lifting interest rates just as the economy was hitting its straps, the sharemarket struggled for the best part of 12 months despite improving corporate earnings.
The precipitous power of monetary policy can also be seen when the Fed eases rates. In 2008 the Fed sprayed the world with money and the sharemarket took off and has registered a monumental gain of 115 per cent.
When central banks are forced to lift interest rates they will normally undertake a series of increases that changes the dynamics of all investment categories including equities. Company valuations become less attractive and storing funds in cash becomes more attractive. Obviously, the overall impact of this depends on the magnitude of the rate increases, but rising interest rates are rarely good signs for equities. This could lead to a nasty correction in US share prices in 2014.
The level of contemplation of how the Fed will unwind its loose monetary policy has filtered to its counterpart in Australia. The Reserve Bank of Australia governor, Glenn Stevens, recently publicly mused for the first time how difficult and complicated the task will be.
For Australia, the game is at a slightly different stage. Obviously the RBA has not needed to print money to keep the economy afloat. In more recent times though it has slashed rates by 175 basis points. Economists are now forecasting further easings anywhere between 25 and 100 basis points in 2013, which should be a tremendous boost to both the domestic economy and local sharemarket. But like its US counterpart the RBA will at some stage begin to think about reversing monetary easing. As of now this policy switch might not take place until well into 2014, but if the share market rallies between now and then we may well be in for a difficult time on our sharemarket as well.