Economists forecast that money market rates are about to turn around during the next couple of months. What does this mean for other major asset classes? |
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Money Market Rates Influence Equity and Bond Markets
With the money market rates taking a turn for the better, this article analyzes the performance of the equity and bond markets over the past year to better understand the impact it would have in other major asset classes.
Economists forecast that money market rates are about to turn around during the next couple of months. What does this mean for other major asset classes?
To get an idea, we analyzed the performance of equity and bond markets 12 months before and after 53 turning points of money market rates in five countries since 1986. We find that the relative performance of equities versus
bonds is in favour of equities when money market rates turn from a cyclical low and start to rise. However, the opposite is true for phases when money market rates start to fall from a cyclical high; then bonds tend to be more
favourable than equities.
Economists at UBS Wealth Management Research forecast only slightly lower money market rates in the US for the next few months, and then slowly increasing rates. The same pattern is expected for the EMU and Switzerland. Since
monetary policy is the main driver for short-term money market rates, these expectations also reflect the common assumption that economic growth will gain momentum and that the world might get closer to almost normal growth rates.
Will this change in monetary policy affect other asset classes? Some people might claim that a tighter monetary environment will put pressure on equities and bonds, while other people might emphasise that a better economy goes
along with better earnings prospects. At this point, we do not want to enter this debate, but empirically test if there are some consistent patterns during periods when money market rates turn.
We define two characteristic states: one when the money market is at a cyclical high and the other when it is at a cyclical low. A ‘low’ is characterised by a money market rate that is the lowest over the last 12 and the next
12 months and that is at least 1% point lower than the highest money market rate over the same time period. Accordingly, a ‘high’ is characterised by a money market rate that is the highest over the last 12 and the next 12 months
and that is at least 1% point higher than the lowest money market rate over the same time period. These definitions allowed us to identify 53 turning points (27 highs and 26 lows) since 1986 in the five countries we took into
consideration, which are Switzerland, US, Germany, Canada, UK and Japan. Then we indexed the equity performance, so that the index is 100 during the month when money market rates turned. Finally, we calculated the averages over
these indices.
Chart 1 shows the average development of the underlying five MSCI country indices 12 months before and after the money market lows and the highs.
On average, equities have started to perform relatively well a few months before the overnight money market rate has reached its cyclical low and then continued this favourable development for the next 12 months. On average,
markets have increased by about 20% during these periods. In contrast, around the high turning points equities have remained relatively lethargic.
As Chart 2 shows, the picture is somewhat different for bonds during these periods. Bonds generally perform better during periods when money market rates start to fall.
In contrast, around low turning points this asset class behaves relatively sluggishly.
When we finally combine the two asset classes and look at the performance of equities relative to bonds, the past would tell us to prefer equities rather than bonds when money market rates start to rise. During these periods,
equities have outperformed bonds by about 10%. However, we should prefer bonds to equities when the money market rates start to fall since bonds then tend to outperform equities.
How is this possible? According to efficient market theory, equity and bond markets should anticipate changes in monetary policy and not react in any particular way.
However, behavioural finance claims that investors are myopic and are following a herd instinct. This would lead to the conclusion that in times when the economy is relatively bad, like these days, investors become pessimistic
about the future in general. Equity markets are therefore rather sluggish when interest rates are low. However, when the central bank starts to increase money market rates, this is taken as a signal that the situation has changed,
the economy will pick up and earnings prospects will improve. Long-term interest rates in these phases tend to increase slightly. If behavioural finance is right, the picture might easily repeat itself in the near future.
Achim Peijan
UBS Wealth Management
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