Stephen King: Interest rates down, stocks up but it's no 90s revival

Central bank constitutions are too rigid to deal with the changing economic environment

Are we going back to the good old days? The left-hand chart certainly suggests that something is up. The chart tracks the relationship between 10-year gilt yields and the FTSE 100 index of share prices since the beginning of 2003. For the first three months of this year, stock prices fell in line with declines in long-term interest rates. Over the last few weeks, however, the relationship has gone into reverse. Now, when interest rates go down, stock prices go up.

The relevance of this changed relationship can be seen from the right-hand chart. This tracks the same two series over a much longer time horizon, going back 17 years or so. The chart shows that developments in recent weeks have pushed markets back to the behavioural patterns that typified the "roaring 90s". Throughout the last decade, bond yields fell and equities rose. Many equity strategists argued at the time that lower bond yields implied a lower discount rate on future company earnings and, therefore, explained why share prices should be going up.

So, on the face of it, this return to "normal service" seems rather encouraging. But why is it happening? What explains the sudden reversal? Can we be sure that this new relationship will hold?

Let me start with a general observation. The change in market behaviour in recent weeks is not a phenomenon that is unique to the UK. This is as true in the UK as it is in the US, in the eurozone and in many other places. Around the world, both equity and bond prices have been on the rise.

However, it's also worth noting that the experience of the 1990s was a bit of a peculiarity and, ultimately, may have been based on very shaky foundations indeed - as, of course, many people found to their cost in 2000 when the equity bubble burst. A number of aspects of the 1990s experience were based on fairly weak logic.

As interest rates came down, people argued that equities were a better buy. But they conveniently forgot that rates were falling in part because inflation expectations were also coming down. That meant that estimates of company profit growth should also have fallen. At first, however, they stayed very high, caught up in the intoxicating atmosphere of the "new paradigm". Only later did profit expectations fall, as the bubble burst.

People also thought that low inflation would reduce the risks of boom and bust. In one sense, this argument was right: the 2001 global recession was mild and, in some cases - the UK, for example - never materialised in the first place. However, this argument no longer looks quite so clever. The risk of inflationary boom and bust may have faded but deflation is now becoming a much bigger concern: and, as I have argued in this column before, deflation is a particularly malignant threat to economic stability.

People also began to believe in the supremacy of central banks. They could do nothing wrong because they were now free of political influence. And, as a result, they would not make the "political" mistakes that had led to boom and bust in the past. Yet, as we're now beginning to discover, it might be the case that central bank constìtutions are too rigid to deal with the changing economic environment. Credibility against inflation is very useful when inflation is too high, but what of when it's too low?

People also began to believe in the supremacy of central banks. They could do nothing wrong because they were now free of political influence. And, as a result, they would not make the "political" mistakes that have led to boom and bust in the past. Yet, as we're now beginning to discover, it might be the case that central bank constitutions are too rigid to deal with the changing economic environment. Credibility against inflation is very useful when inflation is too high, but what happens when inflation is too low?

If these arguments are right, there is no strong case for returning to the "roaring 90s" model. Normal service will not be resumed because the service of the 90s was never normal. So what explains the return to "roaring 90s" behaviour?

One way to square the circle lies in the growing belief that the Fed will use "unconventional policies" to deal with the threat of deflation and that these policies will work, thereby saving the world economy. In these circumstances, what would you expect to see?

First, you would expect to see lower long-term interest rates. The Fed has already hinted at the need to cut long-term interest rates in a situation where short-term interest rates are already close to zero while 10-year Treasury yields have fallen dramatically this year and, recently, have got to close to just 3.3 per cent. Second, you would expect the dollar to weaken. On the assumption that the US is more willing to use unconventional policies than, say, the eurozone, the dollar should come down. And, generally speaking, that's exactly what has happened.

Third, you would expect equities to rise in value. If the unconventional policies work, the economy will recover and company profits should begin to pick up. The bad times will eventually go away and all thoughts of stagnation, deflation and depression would fade from our collective memories.

I reckon, then, that all bets are on for unconventional success. Yet I have my doubts. Cutting long-term interest rates - however you do it - is little more than an extension of the short-term interest rate cuts that we saw in 2201 and 2002. They, ultimately, did not work very well: economies failed to recover in the expected manner. Cutting long-term interest rates is the option you pursue when you can't cut short rates any further but what happens when long term interest rates themselves fall close to zero? It's happened in Japan but no one there is talking about a healthy recovery in economic activity.

It seems to me that there are two dangers inherent within the current situation. The first is that the unconventional policies will not work terribly well: if debt levels in the private sector are too high in the first place, encouraging people to borrow more by cutting long-term interest rates may defer, rather than deal with, the underlining economic problem. The second is that, even if economies do eventually re-bound, it is a lot less obvious that there will be a decent rebound in corporate profits. If technology has increased the amount of competition around the world, companies are going to find it a lot more difficult to hang on to the high profit margins they so much enjoyed in earlier decades. So any rebound in equities may be a rather fragile affair.

Ultimately, I have no problem with markets making the bet on unconventional policies. I do, however, have some problems with the idea that the policies are bound to work. And, for that reason, I suspect that the bet on bonds is somehow more secure than the bet on equities. In the short term, the pursuit of unconventional policies should ensure lower bond deals, whether or not the policies ultimately lead to a sustained recovery in economic activity. Equities, however, will only make headway if the unconventional policies actually work. And, as we have learned over the last two years changes in policy no longer provide the guarantees of economic success that we so enjoyed in the past.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com