Rate cuts may come sooner or later than the market is pricing but that does not really matter. 

Developed-country central banks are stepping towards an easing cycle. The problem, as usual, is that the market wants to run, not walk. Investors want to buy assets ahead of a possible surge in prices as they know that the last two easing cycles have created what many describe as “everything bubbles”. But those easing cycles were very different, so does it imply that there can’t be another surge in assets this time around?

Central bank rate cuts look as if they are coming next year with the Bank of Japan probably the only one that will resist. Cuts may come sooner or later than the market is pricing but that does not really matter. What matters is that easing cycles have typically bought rallies in asset prices; both bonds and stocks.

What’s more, the last two easing episodes, during the global financial crisis (GFC) of 2008 and the pandemic of 2020, have unleashed huge multi-year asset price rallies once the initial shock of the financial crisis and the pandemic were over. But straight away we can see why this coming easing cycle will probably be different. There’s no crisis; policy rates aren’t likely to be driven to zero or near-zero levels, and central banks won’t be doing quantitative easing.

If the everything bubbles after the GFC and Covid were created by the ‘natural’ recovery in asset prices after adverse shocks, zero rates and asset purchases by central banks, it looks as though the upcoming easing cycle won’t produce the same magnitude of asset price strength, at least as far as risk assets like stocks are concerned (bonds could be a different matter because inflation has risen rapidly and is coming back down, so seemingly ensuring a rally, at least in short-dated paper).

Instead, we appear to be looking at what we might call a more traditional easing cycle; one that is not kicked off by an adverse shock; where policy rates don’t have to fall to zero, and where central banks don’t have to supplement rate cuts with huge asset purchases. On QE alone, the assets of the three major central banks: the Fed, ECB and BoJ currently stand at around USD20tr; a five-fold increase on the level seen just before the GFC.

To put this in context, if central bank balance sheets had continued to grow at their pre-GFC pace in the subsequent fifteen years, their combined assets would have probably been in the region of USD5-10tr today; not USD20tr. If central banks have bought all these assets and essentially ‘given’ the cash to investors so that they can go out and buy their own bonds, stocks and whatever else they wanted, it is little wonder that an everything bubble has occurred – twice.

Coming back to today, assets are being shrunk not expanded by the central banks and although rate cuts are coming, most seem to expect that policy rates won’t fall to anything like zero again. Can asset prices still surge when zero rates and QE are not part of the story?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said the obvious answer seems to be “no”. But he doesn’t think it is quite so obvious. For one thing, the last year, or so, seems to have shown that longer-term inflation expectations are quite well anchored and hence the output (or employment) cost of bringing inflation back to target has not been as high as feared.

The last general bout of sky-high inflation amongst developed economies was in the 1970s and 80s and defeating this came at a cost of deep recessions and high unemployment. It may still be early days yet but it does not seem that the world has had to endure such consequences this time around and, in our view that’s good news for asset prices.

Another point comes from the second word of the term ‘everything bubble’. For the ‘bubble’ part of this story reflects the contention that central banks have artificially created asset price strength through plying their economies with huge quantities of cash via QE. Faced with such a deluge of cash, and with the yield on cash at zero, or near-zero, investors have gorged on assets and that’s led to an inevitable bubble – and bust. If, this time around, asset price strength can be more measured, and more based on policy success, than artificial monetary largesse, then asset price rallies can both occur – and prove more durable.