The post-financial crisis environment has frequently been described as the “new normal”. This is somewhat ironic as “normal”, unless prefixed with “ab”, is one word I would not use to describe the eventful period we have been through, and which we are likely to continue to witness. Rate cuts, quantitative easing, yield curve control and negative bond yields – lenders paying borrowers – what’s so normal about that? Globally, we have had over 1,100 global central bank rate changes, including just over 700 rate cuts. 700 rate cuts! The great unwind, which has recently begun, is likely to prove to be anything but straightforward.
The tide of easing
To visualize the extraordinary monetary accommodation that central banks have delivered, we created a “diffusion index” of rate hikes minus cuts (negative means net cuts). This is a simple number count that scores a move as a move, irrespective of identity of the central bank or size of the move. The point here is simply, and only, to observe the pattern that has rippled across the world:
It can be seen from the above that following cut after cut after cut, momentum has finally turned, at least in the developed world. The momentum has yet to turn in EM and is one of the reasons why we continue to believe that good opportunities remain in the EM world.
Another way of visualising the flood of easing that has been delivered is to look at cumulative cuts that have been delivered (and this does not even include central bank balance sheets which also have to be unwound):
On to the great unwind
Typically, a business cycle lasts around 6 years, and not coincidentally, an interest rate cycle typically lasts around 6 years too. The current period of economic expansion has therefore been extraordinarily long, almost 10 years and counting, but we know that the days of super low global central bank rates are in the process of coming to an end. For the Fed, that actually started two years ago. Nevertheless the pace of hikes has been slow and protracted.
We started with a light hearted way of looking at the tide of easing that has been delivered by central banks. We move onto a more serious note. What is key is that nominal and real rates of interest globally are currently extraordinarily low. At just over 1% nominal, the real Fed Funds rate is still negative two years after the Fed first hiked! The Fed believes that it can attain a “long run” rate of 2.75%, perhaps not in the current hiking cycle but in the undefined “long run”. Even so, this will only take the real Fed Funds rate to 0.75%, assuming the Fed achieves its inflation target.
We simply do not know, but what if the real rate of interest eventually goes back to somewhere in the region of 1% to 2%, still much lower than the 3% to 4% that used to prevail (the nominal Fed Funds rate was 5.25%, and the real rate was above 3% on the eve of the crisis)? In this scenario, the nominal Fed Funds rate will need to be somewhat closer to 4%. We are now witnessing a period of synchronised global growth. Where the Fed leads, the rest of the world follows. Statistically, although economic expansions do not simply die of old age, we are likely to witness another recession during the next decade. So during the next 10 years, global central banks may be raising rates, cutting them and raising them again. If it took 700 rate cuts globally to take us to the nadir in rates, it is no exaggeration that over the next decade, we could see perhaps 1,000 rate hikes globally! Exciting challenges lie ahead for both policy makers and investors alike.
Financial markets have been on a long and strong run, but good times cannot last forever. The next few years will reveal those managers who have been buoyed by the tide of global central bank ease, and those who can be relied on to manage risk and navigate cycles as well as market sell-offs. Based on our fundamental, quantitative and technical approach to investing, we firmly believe that we are in the second group of managers that clients can rely on to diligently manage their assets in adverse markets as well as in rising markets. What does this come down to? Insight, process and discipline.