Central banks may have already started to reduce their support for the economy. It is a positive indicator for stocks, although it can lead to short-term volatility.
When the pandemic began, central banks were quick to try to support growth. They lowered benchmark interest rates and bought bonds, raising their prices and lowering their yields. Businesses and households have benefited from the lower cost of borrowing, so they now have more flexibility to spend and invest as virus restrictions are lifted. Falling bond yields are also making equities more attractive, a dynamic that has helped
Now that economies are rebounding rapidly, central banks may soon reduce their support to keep inflation under control and reduce the risk of asset price bubbles such as stocks and real estate. It is the usual playbook in a recovery.
On Wednesday, the Bank of Canada reduced the amount of assets it buys each week to just over $ 2 billion, from just over $ 3 billion.
The European Central Bank left its policy unchanged on Thursday, but if the pace of Covid-19 vaccinations picks up, eurozone economies could reopen, leading to growth that could lead to reduced ECB support. Members of the six members of the ECB’s executive board and its governing council have already started discussing the stance of monetary policy once the recovery is on a firmer footing.
Some have speculated that if the Federal Reserve has reiterated that it sticks to current policy for the time being, a rapid pick-up in inflation could force it to reduce its support. “Yesterday is probably the day central banks began the long return to some kind of ‘normal’ monetary policy,” Tom Essaye, founder of Sevens Report Research, wrote in a note.
Equity market volatility could increase in the near term if more central banks follow Canada’s lead, reduce bond purchases and allow yields to rise. The 10-year Treasury yield would likely rise when the Fed cuts the size of its purchasing program, given that it is still below the expected long-term inflation rate, whereas it has always been below. above this level.
Higher yields would certainly pose a risk to the US market, which is currently highly valued. S&P 500 stocks are trading on average at 22.5 times expected earnings per share for the coming year, but many strategists believe the multiple should only be 20 times. Higher rates reduce the present value of future cash flows, so investors may not be willing to pay that much.
“It will create episodes of volatility,” Essaye said of the potential rise in yields.
Over the longer term, however, less monetary support would likely indicate economic strength, an environment conducive to inventory gains. Profits would rise, which could push stocks higher even if higher returns lower multiples or stock prices relative to earnings. According to FactSet data, analysts expect profits to rise at least until 2023.
The big risk is that a too rapid rise in yields could hurt the economy and profits.
Write to Jacob Sonenshine at [email protected]