The consequences of ultra-loose central bank monetary policy

Mark Haefele, global chief Investment officer at UBS Wealth Management

Markets reacted positively to quantitative easing when it was first deployed by the US Federal Reserve during the global crisis. And when the European Central Bank (ECB) and the Swiss National Bank introduced negative interest rates in 2014, it caused little upset in financial markets.

But the Bank of Japan’s surprise move to sub-zero interest rates in January marked a change in the historical reaction function to central bank policy. Usually greeted with equity market cheer, the rate cut precipitated a sharp decline in Japanese banking stocks. This reaction was repeated in March, when eurozone financial stocks fell after the ECB cut rates more deeply into negative territory. This demonstrates growing unease about the impact of negative interest rates on bank profitability. Lower long-term yields are also now raising questions about the health of the insurance and pension industries, which may need to take excess risks to meet their obligations.

On the other hand, the bond market reacted with perhaps too much cheer. Short-maturity bonds received a boost, as can be expected, but long-dated bonds staged an even sharper rally. This suggests that markets are sceptical about the long-term positive effect of negative rates on growth and inflation. Currencies have also stopped behaving by the book. Instead of depreciating, the Japanese yen appreciated in response to the BoJ’s rate cut.

In our strategic asset allocation models, which have a time horizon of five-plus years, the plunge in yields across the maturity curve means that the already muted long-term outlook for high grade fixed income has worsened. With that backdrop, we see greater potential for risk-adjusted returns in a properly managed portfolio of hedge funds than high-grade bonds over the long term. We therefore diversify our fixed income allocation across a wider range of monetary regimes to mitigate portfolio risks that result from the experimental new policies central banks are adopting.

Alternative asset allocation concepts can also help investors find better returns without taking on unacceptable risk, a growing challenge in the face of negative rates. Such concepts can: a) provide investors with exposure to stocks in normal markets, but reduce allocations sharply when systematic analysis shows risks are elevated; b) enable investors to seek higher returns in exchange for investing in illiquid assets; and c) utilise the whole fixed income spectrum to offer bond investors greater returns.

In the shorter term, the concerns raised by negative interest rates will be a key market driver, as will the evolution of Federal Reserve policy. Our tactical view remains that negative rates may be imperfect, but they demonstrate central bank willingness to continue to innovate and supply liquidity to global markets. We remain overweight equities in the US, where we think earnings will improve and the Fed will remain sufficiently accommodative. We are also overweight high yield bonds in Europe, where we think the economic recovery will continue and ultra-low rates will continue to force investors into higher-yielding fixed income assets. We believe, overall, that the commitment of central banks will support risky assets over the next six months – but investors should remain aware of the longer-term implications.

Didier Saint-Georges, MD and member of the Investment Committee at Carmignac

It is hard to ignore the fact that unconventional monetary policies have mostly failed since 2009. The problems facing the global economy – overleveraging and insufficient demand – will not be resolved by monetary policy alone, and central banks’ squeeze on interest rates is now exacerbating the situation it was supposed to ease in the first place: encouraging governments to continue borrowing, weighing even more heavily on banks’ profit margins, and increasing consumers’ savings requirements instead of boosting spending.

Let us take a look at what happened since 2009. The global financial crisis drove most governments to defer all their economic powers to central banks, who as the dominant market plays have tried all sorts of innovative policies to ease financial conditions and encourage investors to rebalance their portfolios towards riskier assets. Not only has this had little effect on the real economy, it has also generated major iatrogenic (unintended and toxic) side-effects. Central banks are now effectively captives to their own policies, and this spells deep trouble for investors.

Be it in the US, in Japan or in the eurozone, one of the principle objectives was to stabilise inflation rate levels near 2 per cent. This is far from being achieved, as inflation expectations have declined and are now anchored well below target levels. As Mario Draghi himself admitted, the ECB’s credibility is at stake on this performance measure, justifying, in his view, the pursuit of unconventional policies until the inflation mandate is fulfilled. 

In the US, deflationary pressures remain powerful, driven primarily by industrial excess capacity globally and – importantly – by the hysteresis of the 2008 credit crisis, which incentivises individuals and companies to favour saving over spending. Cruelly, the recent pick-up in inflation readings is largely due to the rise in rents, in healthcare costs, and most recently in oil prices. Such price increases will actually act as a tax on discretionary spend, putting added pressure on the consumer. Further monetary tightening by the Fed would not only work against the needs of the US economy, but it could also trigger additional risks in dollar-hungry emerging countries, with a negative feedback loop on the US economy.

Take Japan. The failure of Abenomics and the Bank of Japan’s monetary policy to spur economic growth is plain to see, as industrial production has remained flat in the last two years. There is no question that if unconventional monetary policy is meant to continue until it has reached its inflation and growth targets, it has a long way to go.

Financial repression has profoundly affected market prices, as central banks’ literal “underwriting” of markets has raised investors’ acceptance level of equities and bonds’ valuations to sky-high levels. Should central banks indicate a radical move away from past policy, a brutal reset of asset prices would ensue, with a negative impact on confidence and wealth effect.

This overall diagnosis leaves central banks in a more and more uncomfortable position – and investors should worry about it. The banks’ failure to achieve their growth and inflation targets so far would justify that they pursue their efforts. In addition, the very imbalances they have created make it very risky for them to withdraw their support, lest it trigger more stress in the global financial system. But by the same token, to paraphrase Einstein, doing more of the same and expecting a different outcome would be insane. So something will have to give. Some observers are starting to evoke Milton Friedman’s “helicopter money” solution, whereby central banks would go all-in and print to directly feed the money supply. Or markets might finally have to recognise that the economic impact of the global financial crisis was delayed for many years, courtesy of central banks’ unorthodox actions. But procrastination can only last so long.

Paul Lambert, head of currency, Insight Investment

The institutional arrangement of independent central banks addresses yesterday’s problem of too much inflation. Markets recognise that central banks are able to cap inflation via monetary policy tightening regardless of the election cycle – their independence instils credibility. Now, faced with today’s problem of very low inflation, central banks have responded with aggressive “conventional” interest rate cuts coupled with “unconventional” quantitative easing (QE) in order to stimulate rising prices. Monetary policy certainly has a further role to play in addressing the economic woes we face, but its efficiency has deteriorated and unconventional policies have created potentially undesirable externalities.

Historically, when interest rates were cut, the yield curve would steepen. Borrowers would want to borrow more because the cost of money had fallen and savers would want to save less because the reward for doing so had diminished. Banks, who borrow short-term funds and use them to lend long-term loans, would experience wider margins as the yield curve steepened and so they would be happy to lend more. Today, negative rates and bond purchases have led to a flattening of the yield curve in Europe and Japan. While borrowers may have been more willing to borrow and savers dis-incentivised to save, banks will have seen their margins fall as the yield curve flattened and would likely feel less inclined to lend. The response of borrowers and lenders to monetary policy easing is no longer well aligned.

This misalignment has led central banks to increasingly look at credit easing to deliver a boost to the economy. However, in the case of the eurozone and Japan, most lending takes place through the bank lending channel, not the bond credit channel. This means some central banks are no longer operating in the most important lending market, especially with respect to small businesses and consumers.

In terms of the externalities of monetary policy, it is clear that the purchase of credit by central banks has had a significant impact on the issuers and the owners of the securities bought. By buying these bonds central banks are not only impacting the risk-free rate, which is normal, but also the credit spread. This credit spread should reflect factors such as default risk and liquidity, but with a price-insensitive buyer the price of securities becomes misaligned with fundamentals.

Moreover, the credibility of independent central banks was an advantage when attempting to reduce inflation, but may be a hindrance in trying to boost inflation. Consumers are likely to bring purchases forward only if they believe the central bank has a bias for higher inflation stemming from short-term growth. The market is arguably more likely to believe this from a politician who has an election cycle to worry about now rather than a central bank that must consider the consequences of a recession later and attempt to get inflation back under control.

Ultimately, central banks respond to economics and since the crisis, central bank policies have been driving the markets rather than fundamentals. While economic data from the US has recently been firmer than its main trading partners, we are uncertain about its magnitude. Given this unstable equilibrium and understanding that the central bank will act independently of market reaction, caution is the order of the day.