The wind beneath the market’s wings
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Global stock markets have been remarkably resilient of late, taking in their stride both unsettling political developments and interest rate hikes by the US Federal Reserve. The most recent example comes from the markets’ rather blasé response to the defeat of Trump’s healthcare bill, with equities shrugging off the debacle. Indeed, with valuations soaring skywards, analysts at Bank of America Merrill Lynch have dubbed the stock rally the ‘Icarus trade’, after the mythical Greek Icarus, who ignored warnings and flew too close to the sun on wings made of feathers and wax---the heat melted the wax and Icarus plunged to his death. It’s a classic tale of hubris and nemesis.
There have been many attempts at rationalising the current upbeat sentiment on the bourses. In the US, optimists point to Trump’s promises of huge tax cuts, deregulation and spending on infrastructure. Another explanation is that global growth is picking up and therefore the Fed’s tightening of monetary policy doesn’t matter. Others point to higher growth in the euro zone and more stimulus from China. Global trade too is increasing, after many months of near-stagnation. And the political risk in Europe may have been over-stated.
But there exists a much simpler reason for the optimism in the markets--despite the recent hike in the US policy rate, global monetary conditions have eased, not tightened, says a note dated 27 March from Citi Research. Says the note: “According to our monetary conditions index (MCI), G4 monetary conditions have not tightened but probably eased – by the equivalent of a decline in the real interest rate of 90bp since mid-2016 and by 50bp since the start of 2017. According to our measure, they are now at their easiest level since Jan-2015.” Real policy rates remain negative across the G4---the US, UK, euro zone and Japan. The Citi Research note defines their monetary conditions index as the weighted average of the real policy rate, real long-term government bond yields and of the REER as deviation from its previous three-year average. Citi research says that on this broader measure of G4 monetary conditions, there is no clear sign of tightening in 2017 or over the last year and instead, monetary conditions may have eased due to rising inflation, higher inflation expectations and (ex-US) weaker exchange rates.
Indeed, by this yardstick, the euro zone currently has close to the loosest monetary conditions since the creation of the monetary union. As far as real long-term rates go, while they have risen since mid-2016 in the US, they are still below their levels last December. In Japan, the UK and the euro area, real long-term yields are still negative. Says the note: “Increasing inflation and FX effects have eased monetary conditions in all countries except Japan.”
What’s more, the Citi researchers do not expect monetary conditions to tighten in the near future. Says the note: “Looking forward, we should expect average AE (advanced economy) monetary conditions to remain close to current levels.”
Loose monetary conditions are, of course, good for risk assets, including equities and also emerging markets. Icarus, it seems, could fly even closer to the sun.