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Can central banks keep the party going?

Tom Stevenson

Tom Stevenson - Investment Director

All eyes are on the Federal Reserve ahead of this evening’s interest-rate announcement. For those with long enough memories, the comparison being drawn is with 1995.

Can central banks keep the party going?

That was when the Federal Reserve last stepped in to defend a long-in-the-tooth economic and stock-market cycle with a series of precautionary interest rate cuts. The market’s recent rally to close to an all-time high in America reflects a belief that the Fed might repeat the same trick today.

Back then, the market was reeling from an unexpectedly aggressive tightening in monetary policy from the beginning of 1994. The Fed had raised rates from 3.25% to 6% in just over a year. The long bull market which had been running since 1982 looked finished.

That is when Alan Greenspan, then Fed chair, stepped up and cut interest rates back to 5.25%. It was just what the market needed, and the bull run was given a fresh lease of life. Three years later when crisis hit in the form of the collapse of the Long Term Capital Management hedge fund, he did it again, cutting rates from 5.5% to 4.75%.

That paved the way for the market’s final leg up to the dot.com peak in 2000.

There is a saying that you should never bet against the Fed. Certainly, it is wrong to underestimate the power of the US central bank to rekindle a flagging bull market.

That is why Donald Trump is so overtly putting pressure on current Fed chair Jay Powell to reverse the recent tightening of policy. With a Presidential election looming at the end of next year, the President knows better than most the importance of keeping the economy and the market on track.

This evening, the Fed will probably leave rates on hold. With the stock market close to an all-time high and unemployment at a multi-decade low, it is hard for the Fed to justify a rate cut right now. And Mr Powell is conscious of not being seen to kow-tow to an over-mighty President.

But attention will focus on the so-called dot plots, the graphical illustration of the interest rate expectations of individual rate-setters on the Fed’s monetary committee. As recently as December, these were pointing to a series of rate hikes this year and next. By March, this had been reined in to maybe just one hike. Tonight, we should expect to see forecasts heading the other way - perhaps as many as three quarter-point cuts this year.

The thinking is that with the economy already starting to show signs of slowing the Fed will want to avoid getting ‘behind the curve’. This refers to the situation in which the central bank leaves it too late to have a meaningful impact on the economy.

Sometimes this is called ‘pushing on a piece of string’ which neatly conjures the impotence of too-little-too-late policy moves.

A good illustration of what can happen when the Fed hesitates for too long is what happened after the dot.com bubble burst. Between December 2000 and December 2001, the Fed cut interest rates from 6.5% to 1.75%. Even this dramatic easing was ineffective because it came too late. Between March 2000 and October 2002, the S&P 500 index pretty much halved in value.

So, what happens this evening and in subsequent Federal Reserve meetings this year is extremely important. If Mr Powell is not daunted by the responsibility facing him, he should be!

For investors watching from the side-lines, how should they arrange their portfolios in this environment? Defensively and cautiously would be my recommendation. The market risks are probably skewed to the downside from here, albeit with the possibility that a definitive move by the Fed could provide shares with a short-term fillip that investors will not want to miss out on.

So, as ever, a well-diversified portfolio, with a balance of bonds and shares from around the world should be the goal.

You can either put this together yourself or, if you prefer, allow professional investors to do the asset allocation on your behalf. The Fidelity Select 50 Balanced Fund is designed to deliver a smoother ride towards long-term capital gains. For many investors, it is not a bad starting point.

More on the Fidelity Select 50 Balanced Fund

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