Central banks take proactive steps to facilitate growth
Monetary policy has direct and indirect consequences that should be considered carefully before every decision. So far, inflation targets, the labour market and economic growth have been the key parameters. But inflation has been trending downwards for many years and has stubbornly remained below the central banks’ target levels. At the same time, social and environmental topics are pushing onto the agenda – not least because they too can have implications for financial stability.
The question is: Is global monetary policy is still pursuing the ‘right’ goals, and is it using appropriate tools to do so? Against this backdrop, both the US Federal Reserve (Fed) and the European Central Bank (EZB) have reviewed their monetary policy strategies. The Fed is one step ahead in this process – it published the most important aspects of its strategic adjustment in August. The findings of the ECB’s review will probably not be published until mid-2021, partly due to the coronavirus crisis.
Evolution with consequences for the yield curve
In its own words, the Federal Reserve is pursuing a path of evolution rather than a revolution. But it has announced two significant changes. Going forward, the bank will be prepared to let inflation rise moderately above the target level of 2 per cent. In other words, its price stability objective will have a ‘memory’. This means that sustained phases of low inflation will make subsequent phases of higher inflation more acceptable.
Another new feature is that US monetary policy decisions will now be informed by assessments of the shortfalls of employment from its maximum level rather than by deviations from its maximum level. This differentiation reflects the belief that a robust job market does not necessarily lead to rising inflation. The significance of the natural rate of unemployment as a guideline for monetary policy will further diminish as a result of this change.
What does this mean for the capital markets? First and foremost, it means that US monetary policy – which dominates global monetary policy – will remain expansionary for longer than previously anticipated. It is unlikely that the Fed will change tack sharply when the first signs of inflationary pressures emerge. The US central bank itself has no expectation of raising interest rates before 2023. Union Investment therefore anticipates that inflation expectations will increase and the markets will price in higher inflation premiums as a result. This is due to the growing uncertainty about the future course of inflation, not least because the central bank is loosening the leash on inflation and allowing for more leeway in its target range.
The US yield curve has already steepened as a result, meaning that yields on long-dated bonds have risen more than yields on bonds with short maturities. This phenomenon is called a ‘bear steepening’ and usually goes hand in hand with an environment in which demand for riskier assets such as (cyclical) equities, commodities and spread products increases while the US dollar would typically weaken in conditions like these.
Real interest rates in the US are driving various asset classes
ECB under pressure
The ECB, on the other hand, is still at an earlier stage of its strategic review. For the second time in its relatively short history, it is going back to the drawing board. According to the President of the ECB, Christine Lagarde, it will not publish its plans for changes until the middle of next year. At the ‘ECB and Its Watchers’ conference in September, Lagarde emphasized that she saw merit in the new ‘backward-looking’ inflation target of the Federal Reserve. This is a subject of some controversy. But it is conceivable that changes could be made to the way in which inflation is measured and to the method used to define the ‘right’ inflation target. However, it remains to be seen whether the ECB will be willing to convert its pandemic emergency purchase programme (PEPP) into a regular asset purchase programme, as some observers seem to anticipate.
The ECB could break new ground by taking on a more prominent role in the fight against climate change and by changing the emphasis it chooses to place on this topic from a stability policy perspective. One factor in this context could be whether future asset purchases by the ECB will also include bonds from issuers such as the European Investment Bank (EIB), which help to finance the European Green Deal and climate-friendly projects. But EU member states might be concerned that this would result in a loss of fiscal sovereignty if these purchases were expanded. Yves Mersch, a member of the ECB’s Governing Council, explained in an interview that the transition towards a more environmentally responsible economy would need to be financed. But in his opinion, this should not fall entirely within the remit of the central bank. Mersch believes that it would be unhelpful for the central banker to be perceived as politicians.
Whatever the ECB decides to do, it will have to take account of US monetary policy in the process. Tensions are likely to arise on the subject of exchange rates. The euro has appreciated significantly against the US dollar due to steep interest-rate cuts in the US and real rates of return in the country dipping back into negative territory. Further verbal interventions by the ECB against a stronger appreciation of the euro would be possible. If the appreciation trend persists, the bank might decide to lower the deposit interest rate (in conjunction with an expansion of the scope for exempt surplus reserves of banks, i.e. a higher ‘multiplier’). But in terms of interest rates, the ECB has very little room for manoeuvre remaining.
It takes time for fiscal programmes to take effect
One factor that could play a role in the central banks’ monetary policy decisions over the coming years is the effectiveness and scope of governments’ fiscal stimulus programmes. In the wake of the coronavirus crisis, many governments have adopted extensive economic support packages (see chart), causing a spike in sovereign debt. Countries able to access funding at favourable rates, like Germany, are more easily able to manage this increase in debt than countries that are facing financing costs that could threaten the sustainability of their national debt and which do not have their own currency-issuing central bank.
By committing to an ultra-expansionary monetary policy approach, the central banks are, in some senses, providing a degree of certainty about future financing conditions. But monetary policy alone cannot generate additional growth. The central banks are therefore highlighting that it is up to governments now to create better conditions, for example for innovation, in order to boost the potential for growth.
A return to austerity is not expected in the foreseeable future
Alongside fiscal stimulus measures, the €750 billion EU recovery fund will also have a decisive impact on risk premiums in the eurozone’s bond markets. This fund is a first step towards closer fiscal integration in the eurozone. The crucial point will be how quickly and effectively the money from the fund can be put to use. It seems likely that the European Parliament will ultimately not stand in the way of its implementation, despite its initial reservations.
But it will be some time before the liquidity from the fund can actually work its magic. Coronavirus support schemes are gradually coming to an end. This will probably have an adverse impact on consumer spending, a key factor for growth, and the momentum of the post-coronavirus recovery is likely to slow as a result.
All in all, the scope of government support measures will probably be reduced compared with the current programmes. Economists and capital markets call this ‘peak policy’: The stimulus is still there but diminishing.
Bleaker outlook for government bonds from eurozone core countries
The strategic outlook for government bonds is shaped by the Fed’s strategic shift. Investors who do not adjust their strategic asset allocation face low to negative coupons and potentially even price falls if bond yields begin to rise moderately in an environment of steady economic recovery after the pandemic. Over a five-year horizon, this is a very likely prospect.
For the equity markets, the immediate impact of the aforementioned environment should be favourable as long as real bond yields remain subdued or drop even further, which would put the expected rate of inflation above the nominal rates of return. According to Union Investment’s experts, a rotation from growth stocks (such as technology stocks) to more attractively valued stocks with high dividend yields (value stocks) will occur only if not just expected inflation but also the actual rate of inflation begins to rise. However, this is unlikely to happen in the next twelve months, in spite of the central banks’ more tolerant approach.
As at 13 October 2020