Investors have had to completely reassess their view of the role of the state in financial markets as a result of the recent crisis.
Governments and central banks have been forced to intervene to avoid a collapse in the global financial system and a possible depression. Across the globe, banking systems have been bailed out, economic stimulus packages implemented and interest rates driven to rock bottom levels. Nowhere have those programmes been more extensive than in the US and the UK.
Talk of an “exit strategy” from these programmes is premature. But investors will soon face a period when they can no longer rely on central banks to backstop the financial system. That could ignite volatile changes in market interest rates, with the risk that investors in a swathe of different asset classes could be badly wrongfooted.
The largesse of central banks has been accompanied by aggressive “Keynesian-style” spending from governments. That has escalated fiscal deficits and heightened anxiety about easy monetary policies. Some investors fear the end result will be inflation, in spite of the current economic weakness. This helps to explain the fall in the value of the dollar and sterling, and the rise in gold to record levels above $1,000 an ounce.
For now, investors have benefited from a dramatic recovery in risky assets. In effect, by making the yields on cash and other secure investments so low, and with central banks buying bonds, governments have been daring investors to buy riskier assets.
But what happens when governments “remove the punch bowl”? Global asset prices have been driven higher by the flood of liquidity and some analysts believe it is only this liquidity that is supporting them. There is a clear danger of another sell-off once stimulus measures are removed and once tax rises and spending cuts to reduce deficits are implemented.
Financial markets may never be given such freedom again. Stronger oversight and tougher regulations are looming, while financial innovation may be curtailed.
Meanwhile the banking system has become even more concentrated. This further enshrines the concept that they are “too big to fail”, forcing investors to face a new era of a more activist state in financial markets.
“The banks are still too big to fail and we know they will be bailed out again, if they fail in the future,” says Chris Watling, chief executive officer at Longview Economics in London.
A bigger issue is the use of the printing press by central banks. Both the US Federal Reserve and Bank of England have greatly enlarged their balance sheets through bond purchases, with the objective of driving long term interest rates lower and fostering an economic recovery.
For some investors, this activist role has been a boon. Long-term rates in both the US and UK have fallen and liquidity has been pumped into the markets.
The process has enabled banks to repair balance sheets ravaged by losses on toxic assets. As they allow loans to consumers and businesses to expire, they are borrowing at close to zero per cent and investing that money in higher yielding bonds, thus locking in a nice return.
“Liquidity is being provided with no real economic activity, there is flood of money chasing parking places,” says Jay Mueller, portfolio manager at Wells Capital.
Sustained, low long-term rates, however, create stress for defined benefit pension plans, while low official rates also hurt investors, reliant on savings for income.
Still, the buying of bonds by central banks has helped soften the blow of rising government bond issuance for now.
”The market can’t ignore the Fed’s presence in the market,” says Gerald Lucas, senior investment advisor at Deutsche Bank. “Once it stops buying, either foreign buyers will have to increase their purchases of US debt, or US private savings must increase to fill the need.”
While evidence suggests the financial crisis is abating, it appears the economic recovery will be accompanied by a long period of high unemployment, particularly as banks are cutting back on their lending.
This makes the timing of any withdrawal of liquidity by central banks a delicate proposition for investors. If it is done prematurely, economies could quickly fall back into recession.
Once the central bank buying is completed, the broad assumption among investors is that these portfolios will be held until the debt matures, a process of normalisation that is seen being the least disruptive for markets.
“Any attempt to sell some of their securities could run the risk of the Fed edging closer to the third rail of policy error by withdrawing the stimulus too soon,” says Bill O’Donnell, strategist at RBS Securities.
But a long period of easy money so as to nurture a recovery in employment, increases the risk of inflation. The banking system might absorb the money that has been created, in which case there is little risk of inflation. If this does not happen, resurgent inflation seems hard to avoid.
“Whenever we have seen periods of sustained money creation, inflation has ensued,” says Mr Watling.
Earlier this month, the Fed said it would “gradually slow” its purchases of agency mortgage-backed securities and end the programme in March 2010.
When the Fed completes its planned asset purchases, it will own almost 17 per cent of the estimated $10,200bn in long-term Treasury, mortgage and agency debt, says Mr Lucas.
In the UK, the Bank of England has the authority to purchase up to £175bn of securities, the bulk of which are government bonds or gilts. So far the Bank holds £155.9bn of gilts, nearly 30 per cent of the market.
The Fed’s buying of mortgages has pulled the average 30-year mortgage coupon down to about 4 per cent from last November’s level of 5.5 per cent, a boon for homeowners with good credit.
“When they back away there will be an impact, and we should see a few bumps for the mortgage market,” says Thomas Higgins, chief economist at Payden and Rygel.