Both the equity and fixed-income markets are likely to receive better news in the future. Both have recovered over the past month, an unusual development given that for much of the last three years they have moved in opposite directions, with fixed income clearly coming out on top. More recently, the stabilization of economic data, a trend reinforced by continued improvement in corporate profitability and balance sheets, has provided some relief to equity markets. However, in our view, the key to recent market behavior lies in a shift in policy by central banks, particularly in the United States.
The main problem, according to central banks, is the risk of deflation. The US Federal Reserve indicated at its May meeting that it was concerned about deflation. This has been considered as significant as the Volker Declaration of 1979. On that occasion, the central bank hinted at a more decisive strategy to reduce inflation, and interest rates rose accordingly. Currently, the recent declaration is seen as a step toward adopting a more aggressive stance against deflation.
Ben Bernanke, a member of the FOMC (Federal Reserve's Monetary Policy Committee), gave us an idea of what this means in practice in a speech late last year. Bernanke emphasized the steps a central bank could take to avoid deflation: maintaining a buffer against zero inflation and acting more preemptively and aggressively than usual in cutting interest rates.
Ben Bernanke also analyzed the policy options available once short-term interest rates have fallen to zero and the economy is experiencing deflation. These unconventional measures included:
(a) adopt strategies to reduce long-term interest rates and flatten the yield curve,
(b) injecting money directly into the economy through the banking system,
(c) buying foreign assets in order to weaken one's own currency and, finally,
(d) increase the money in circulation (i.e., issue money).
In fact, we are already seeing elements of the policies (a), namely, flattening the yield curve and (c), weakening the dollar. By announcing its concern about deflation, the Federal Reserve indicated that a prolonged period of low interest rates is likely. This has contributed to flattening the yield curve, driving 10-year yields to their lowest levels since the early 60s. Thus, although the Federal Reserve has not announced a program to directly purchase Treasury bonds, its words have had the same effect: they have reduced borrowing costs for households and businesses. Similarly, although policymakers have not actively sold dollars, comments by Treasury Secretary Jon Snow have achieved the same result: the dollar has fallen by nearly 4% over the past month, although this decline has been almost entirely against the euro.
Returning to the new world characterized by stronger equity markets and lower fixed-income yields, can this environment last? In the long run, no. If policies succeed in regenerating growth, fixed-income yields will rise as interest rates normalize. If policy fails, equity markets will fall as the economy enters deflation. It will take some time to see, but we believe that ultimately policy will succeed and deflation will be avoided. If so, the potential for recovery is greater for equities than for fixed income, whose yields have reached their lowest levels in 40 years.
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