When investors understand the monetary policy subtleties, they position their portfolios to profit from policy shifts and increase returns.
- The primary goal of monetary policy is long-term economic growth.
- Monetary policy may be either restrictive or accommodative.
- Changes in monetary policy may have a substantial influence on all asset classes.
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Monetary policy relates to the techniques a country’s central bank uses to determine the amount of money in circulation and its value to the economy. The primary goal of monetary policy is long-term economic growth. Nevertheless, central banks may have several declared purposes to that end.
Some nations’ monetary policy objectives include promoting maximum employment, price stability, and low long-term interest rates. Others believe that keeping inflation low and steady is the most significant contribution that monetary policy can make to a productive and thriving economy.
Investors should understand monetary policy since it considerably influences their investment portfolios and net worth.
Monetary policy and investments
Monetary policy may be either restrictive or accommodative. When the economy grows too quickly, and inflation rises significantly, the central bank may move to steady the economy by boosting short-term interest rates, representing tight or restrictive monetary policy. The central bank will implement an expansive policy when the economy is slow. This is done by decreasing short-term interest rates to encourage growth and put them back on track for growth.
Thus, the influence of monetary policy on investments is both direct and indirect. The direct influence is via interest rate levels and trajectory, while the indirect impact is via inflationary expectations.
Monetary policy impacts all major asset classes, including stocks, bonds, cash, real estate, commodities, and currencies. However, the influence of monetary policy is varied and does not always follow the same pattern. Central banks may also use unorthodox monetary policy measures during very difficult circumstances.
Accommodative monetary policy
Equities often rise substantially during times of expansive policy. This expansionary strategy of purchasing market assets, paired with very low-interest rates, enhances stock values because investors find it easier to borrow. The firms they invest in may grow production at a reduced cost.
Bond yields tend to fall when interest rates are low. Their inverse connection with bond prices implies that most fixed-income instruments record significant price gains. This assumption, however, is only valid as long as investors believe inflation is under control. If the policy remains supportive for an extended period, inflation fears may cause bonds to fall rapidly as yields respond to greater inflationary expectations.
During times of accommodating policy, cash is not king because investors choose to put their money elsewhere rather than keep it in low-yielding deposits. Saving becomes less appealing to depositors when interest rates are low. When interest rates are low, property owners and investors will take advantage of the low property rates to purchase properties.
Commodities are the prototypical risky asset and tend to rise during expansive policy times for various reasons. Low-interest rates stimulate risk appetite. Physical demand is high when economies develop rapidly, and exceptionally low rates may lead to inflationary anxieties simmering under the surface.
The effect on currencies during such periods is more challenging to predict. However, it would seem reasonable to expect a country’s currency to fall against its peers. Nevertheless, if most currencies have low-interest rates, the effect on currencies will be determined by the level of monetary stimulus and economic prospects for a particular country.
Restrictive Monetary Policy
When economic growth is strong and there is a serious danger of runaway inflation, central banks implement restrictive or tight monetary policies. Raising interest rates renders borrowing more costly and cools fast growth to keep it in control.
Equities perform poorly during times of restrictive monetary policy because higher interest rates limit risk appetite and render buying assets on margin comparatively costly. However, there is generally a substantial lag between when central banks begin tightening monetary policy and when stocks peak.
This lag effect is due to investor optimism that the economy is developing fast enough to absorb the impacts of higher interest rates in the early stages of tightening. Exceptional short-term interest rates are a significant negative for bonds since investor desire for higher returns drives down bond prices.
Cash performs well during times of restrictive monetary policy because higher deposit rates encourage customers to save rather than spend. Short-term deposits are often preferred during such times to capitalize on growing interest rates.
As predicted, real estate suffers when interest rates rise since it costs more to service mortgage debt, resulting in a drop in demand among homeowners and investors.
During times of tight policy, commodities move similarly to stocks. This way, they retain their upward momentum in the first phase of tightening, falling substantially afterwards when higher interest rates succeed in slowing the economy. Higher interest rates, or the anticipation of higher rates, tend to strengthen the national currency.
Investors may boost their revenues by aligning their portfolios to gain from monetary policy shifts. The kind of investor determines such portfolio placement because risk tolerance and investment objective are essential in making such decisions.
During accommodating policy times, youthful investors with lengthy investment horizons and a high-risk aversion would benefit from a significant allocation in relatively riskier investments such as equities, real estate, and cryptocurrencies. As policy becomes more restrictive, this weighting should get reduced.
These investors cannot afford to be too bullish on their portfolios. However, they must also take steps to preserve capital and safeguard profits. This is predominantly true for senior citizens, for whom investment portfolios provide a significant portion of their retirement income.
Such investors should reduce their stock exposure when markets rise. Additionally, they should avoid commodities and leveraged assets. Such investors can latch in higher rates on term deposits if interest rates seem to be falling.
The rule of thumb for a cautious investor’s equity component is about 100 minus the investor’s age. As such, a 60-year-old should have no more than 40% invested in stocks. If this appears too aggressive for a cautious investor, the equity element of a portfolio ought to be further trimmed.
Changes in monetary policy may have a substantial influence on all asset classes. However, by understanding the subtleties of monetary policy, investors may position their portfolios to profit from policy shifts and increase returns.