How monetary policy affects your investments

Monetary policy (accommodative or restrictive) refers to the strategies used by a country's central bank regarding the amount of money circulating in the economy and its value. The main objective of monetary policy is long-term economic growth, but the central bank can set different targets for this purpose. In the United States, the Federal Reserve's monetary policy objective is to promote employment, stable prices and moderate long-term interest rates. The Bank of Canada aims to keep inflation at around 2%, keeping in mind the idea that low and stable inflation is the best contribution monetary policy can make to a productive economy that works.

Traders and investors need to know the monetary policies of central banks, because they can have a significant impact on investment portfolios.

Monetary policy

 

Impact on investments

Monetary policy can be restrictive, accommodative or neutral. When an economy is growing too quickly and inflation is rising, a central bank can take measures to cool its economy by raising short-term interest rates, which is a restrictive monetary policy. Conversely, when the economy is sluggish, a central bank will adopt an accommodative policy by lowering short-term interest rates to spur growth and put the economy back on track.

The impact of monetary policy on investments is therefore both direct and indirect. The direct impact is felt through the actual level and the direction of interest rates, while the indirect effect is felt through expectations regarding the direction of inflation.

 

Monetary policy tools

Central banks have a number of tools at their disposal. For example, the Federal Reserve has three main tools for its monetary policy:

  • Open market transactions, which involve the purchase and sale of financial instruments by the Federal Reserve;
  • The interest rate applied by the Federal Reserve to deposit-taking institutions for short-term loans;
  • Reserve requirements, or the proportion of deposits that banks must hold in reserve.

Central banks can also turn to unconventional monetary policy instruments during particularly difficult times. In the wake of the global credit crisis of 2008-09, the Federal Reserve was forced to keep short term interest rates near zero to stimulate the U.S. economy. When this policy didn't achieve the desired effect, the FED used successive rounds of quantitative easing (QE), which involved the long-term purchasing of asset-backed securities from financial institutions. This policy exerted downward pressure on long term interest rates and pumped hundreds of billions of dollars into the U.S. economy.

 

Effect of certain asset classes

Monetary policy affects primary asset classes such as stocks, bonds, cash, real estate, commodities and currencies. The effects of changes in monetary policy are summarised below (it should be noted that the impact of these changes is variable and may not follow the same pattern each time).

 

An accommodative monetary policy

  • During "easy money" or accommodative policy periods, the equity markets are generally rising. For example, the Dow Jones index and the S&P 500 reached record levels during the first half of 2013. This stock market rally occurred a few months after the launch of QE3 in September 2012, after the Federal Reserve pledged to buy $85 billion of long-term securities each month until the labour market showed substantial improvement.

  • With their very low interest rates, bond yields tend to be lower and their inverse relationship with bond prices means that securities with a fixed income are indicative of major price increases. U.S. Treasury yields were at their lowest in mid-2012, as 10-year Treasury bills yielded less than 1.40% and 30-year Treasury bills yielded approximately 2.46%. Demand for higher yields in this low-yield environment led to a large number of tenders for corporate bonds, sending yields to new lows and allowing many companies to issue bonds with historically low coupons. However, this principle is only valid if investors are convinced that inflation is under control. If the policy is accommodative for too long, inflation fears may result in a decline in bonds, as yields adjust to inflationary expectations.

  • Money is not king during periods marked by an accommodative policy, as investors prefer to put their money anywhere rather than depositing it in exchange for minimal returns.

  • Real estate tends to be in good shape when interest rates are low, as owners and investors take advantage of exceptionally low mortgage rates. It is common knowledge that the low level of U.S. interest rates in 2001-04 helped fuel the nation's housing bubble.

  • Commodities are known to be risky assets, they tend to appreciate in value during accommodative policy periods for a number of reasons. Appetite for risk is fueled by low interest rates and physical demand is strong when economies are growing. Exceptionally low interest rates can also lead to concerns regarding the level of inflation.

  • The impact on currencies during such periods is harder to determine, but it would be logical to expect to see a nation's currency depreciate when it has an accommodative policy. But what is one to expect when most currencies have low interest rates, as was the case in 2013? The impact on a currency therefore depends on the extent of a country's monetary stimulus as well as its economic outlook. For example, the Japanese yen's performance fell sharply against most currencies during the first half of 2013. The currency fell due to expectations of quantitative easing by the Bank of Japan. It did so in April, pledging to double the country's monetary base in 2014. The unexpected strength of the U.S. dollar, also during the first half of 2013, demonstrates the effect that an economic outlook can have on a currency. The greenback increased in value against almost all currencies in response to significant improvements in housing and employment which fueled global demand for U.S. financial assets.

 

A restrictive monetary policy

  • Equity markets underperform during periods of restrictive monetary policy, as higher interest rates limit the appetite for risk and make it relatively expensive to purchase securities on margin. However, there is usually a significant lag between the time a central bank starts tightening its monetary policy and when stocks/shares reach a peak reversal point. For example, when the Federal Reserve began to raise its short-term interest rates in June 2003, U.S. stocks didn't peak until October 2007, nearly three and a half years later. This lag effect is due to the confidence of investors, who believe that economic growth will be strong enough for corporate profits to absorb the impact of higher interest rates.

  • Short-term interest rates are a big negative for bonds. Bonds suffered a historic decline in 1994 when the Federal Reserve raised its key interest rate to 3% at the beginning of the year and 5.5% at the end of the year.

  • During periods of tight monetary policy, higher deposit rates encourage consumers to save rather than spend. Short-term deposits generally allow one to benefit from increasing interest rates.

  • The real estate market collapses when interest rates rise because mortgages are more expensive, leading to a decline in demand among homeowners and investors. A classic example of the disastrous impact of rising interest rates on housing is the bursting of the U.S. housing bubble which started in 2006. It was largely accelerated by a sharp rise in variable mortgage interest rates, followed by the federal funds rate, which rose from 2.25% at the beginning of 2005 to 5.25% in late 2006.

  • Commodity trading is somewhat similar to standard stocks/shares during restrictive policy periods. The upward trend continues in the initial phase of monetary tightening before being subjected to a sharp decline due to higher interest rates that slow down the economy.

  • Higher interest rates, and even the prospect of higher rates, generally tend to stimulate a nation's currency. For example, the Canadian dollar usually traded above parity with the U.S. dollar between 2010 and 2012, and Canada was the only G-7 nation to maintain a tight monetary policy during this period. However, the currency fell against the greenback in 2013 when it became obvious that the Canadian economy was headed for a period of growth slower than U.S. growth, leading to anticipation of a change in the Bank of Canada's monetary policy.

Increase in interest rates

 

Allocation of the investment portfolio

Investors can increase their returns by allocating their portfolios according to changes in monetary policy. Such portfolio allocation depends on the type of investor one is, because risk tolerance and one's investment horizon are key factors when making decisions regarding these changes.

  • Aggressive investors: during periods marked by an accommodative policy, young investors with long investment horizons and a high tolerance for risk may opt for a heavy weighting of risky assets such as stocks and real estate. This proportion must be reduced when the policy becomes more restrictive. In hindsight, it would have been ideal to invest in equities and real estate from 2003 to 2006 and then to take some of the profits from these assets to invest in bonds from 2007 to 2008, then come back to the stock market in 2009.

  • Conservative investors: these investors cannot afford to be too aggressive with their portfolios, but they also need to take steps to preserve their capital and protect their profits. Especially for retirees, as their portfolios are an essential source of retirement income. For these investors, the recommended strategy is to balance exposure to equities when the markets peak, avoid commodities and leveraged investments while locking in high-rate time deposits when the interest rate trend appears to be on the decline. The basic rule regarding the equity component of a conservative investor is about 100 minus the investor's age, which means that a person that is 60 years-old should not have more than 40% of his capital tied in shares. However, if this still proves to be too aggressive for a prudent investor, the equity component of a portfolio can be balanced differently.
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