By Rabobank
Economists and strategists tend to look at everything through the lens of interest rates, as if these are all important in explaining market conditions. But if we look at this year’s shift in money markets, we’ve seen a significant recalibration of expectations, from seven to three Fed cuts, while stock indices hit one all-time high after another and credit spreads continue to tighten.
It suggests that central bank policy may not be the primary force at play. Instead, if it’s collective risk appetite that drives liquidity, market movements are largely independent of central bank action. The concept of endogenous money creation explains how, arguing that the (shadow) banking system itself influences the money supply through lending and borrowing. Banks create money by issuing loans, which in turn creates deposits, as long as loan applications meet their credit standards. Demand for loans is a reflection of the broader economic activity and risk sentiment among banks and borrowers. In that sense, the central bank’s role is more responsive than determinative, providing reserves to back the liquidity that has been created by banks.
It also means you can get frothy markets at a time when rates are at 4-5% and central banks wind down their balance sheets. Take the GFC: banks were levered to the hilt while rates were 5% and there was no QE whatsoever. Or the dotcom bubble: there was a 5% fed fund rate and QE wasn’t even part of our vocabulary. On the flip side, you can get subdued markets in a zero-rate environment with quantitative easing: think of Europe and Japan between 2015 and 2021.
Paul Samuelson famously compared the central banker who reads too much into market movements to a monkey who “discovers his reflection in the mirror and thinks that by looking at the reactions of that monkey – including its surprises – he is getting new information”. Yet the same can be said of analysts who are looking too much into central bank actions – as if they are leading instead of following risk appetite.
So, at the risk of looking like a monkey myself, let’s reflect on last week.
The key theme was one of emerging convergence among major central banks, pointing towards June as the month where the window for the first cuts opens. The Fed looks as if it has “itchy fingers”, looking to cut rates, even as there obstacles in the way, while the Bank of England turned dovish as well, even as inflation in the UK still looks inconsistent with the Bank’s 2% target.
Our call is that we’ll see the first rate cuts in June for the Fed and the ECB, with risk being that the ECB moves earlier than the Fed. We have the BoE acting a little later, potentially in August.
In a broader context, we’re also seeing convergence. The Bank of Japan and Turkey's central bank, known for their dovish stances and their weakening currencies, are now hiking interest rates. Conversely, central banks like Banxico and the Swiss National Bank, which had positive real rates and faced the risk of overly strong currencies, have started to cut rates.
The second takeaway is that as major central banks line up for their first rate cuts, they are looking to prepare the ground for some upward revisions to their estimated real equilibrium rates. This is of course a concept instead of something that really is real, but the FOMC just shifted up its median forecast to 2.6% from 2.5%. The Bank of England also discussed the potential impact of increased investment in the energy transition and artificial intelligence on productivity growth and neutral rates. And the ECB’s Schnabel made a speech about rising R-stars too. So the picture is one of both rate cuts and higher-for-longer.
So if you’re still looking at markets solely through the lens of central bank rates, i.e. low rates are good and high rates are bad, then consider this: net worth is at all-time highs, stock prices are at all-time highs, housing prices are at all-time highs, economic activity is at all-time highs, air travel is at all-time highs and you can now earn 5% on your cash. Yes, that’s just risk appetite, monkey.
