Archives for July 2013

The Global Monetary Policy Kaleidoscope

In 2009, in the face of a global economic crisis, the major economies of the world came together and acted in concert to ease monetary policy aggressively.  Together with fiscal stimulus in the US and China, these policies helped to prevent the world from slipping into depression.  Four years on, the economic conditions around the world vary enormously, and the appropriate monetary policies are now very different (though for all countries fiscal restraint is deemed necessary).  These differing monetary policies are producing clear differences in how the local financial markets are performing, and in 2013 there has been a much greater dispersion of performance between equity markets around the world than in 2012.

The economy with the most aggressively easy monetary policy (relative to the size of its economy)  is currently Japan, where in response to the lead of the new Prime Minister, the new Bank of Japan Governor has begun a programme of doubling the country’s monetary base in just two years.  This is being done deliberately to raise the rate of inflation in Japan from the negative rates seen in recent years to the new target of 2%.  To bring Japan out of its 20 year deflation, policymakers have articulated that inflation, and inflation expectations, need to rise to boost the nominal growth rate of the economy.  Should the current policy settings not be sufficient to do this, it is expected that policymakers will move monetary policy to an even easier stance.  The weaker yen that is likely from this policy should be instrumental in helping to boost inflation.

Next is the US, where currently the QE programme is about $4bn of new money creation every day that the financial markets are open.  Before the latest Japanese policy move, this constituted the most aggressive monetary easing.  However, the recent furore following Bernanke’s comments about the tapering of the QE policy indicate the sensitivity of markets to changes in the direction of US monetary policy.  Bernanke tried to argue that tapering a policy of printing $4bn every day to one of printing $2bn or $3bn was still a very accommodative policy; the markets however appeared to interpret it as a tightening of policy.  The rise in US bond yields since May shows that a policy that is easy, but less easy than it was, creates different expectations in the minds of investors, and the Federal Reserve’s words have thus changed the thinking of investors.

Both the ECB and the Bank of England are at a similar phase in their monetary policy.  Both have pursued unconventional policies in the past, the ECB with their three year LTROs and the Bank of England with their own QE programme, but have done little recently to move policy easier.  However, the new Bank of England Governor has clearly been tasked with boosting economic growth in the lead-up to the next election, and the ECB is concerned about the continued poor performance of the Eurozone economy.   The recent rise in bond yields that began in the US and spread across the Atlantic has been unwelcome as it raises the cost of borrowing for business and so offsets the otherwise easy policy in both the UK and the Eurozone.  A further easing of monetary policy can therefore be expected from both Central Banks, and crucially, for markets, the direction of monetary policy is still moving easier, in contrast to the US.

In China, markets have been surprised by the actions of the People’s Bank of China in not providing sufficient liquidity for the interbank market to operate smoothly in the face of liquidity pressures.  This caused overnight interest rates briefly to move above 10%, and has been interpreted as a lesson to the banking system that they have been too carefree with their lending and need to cut back.  This is effectively an act of policy tightening, though it is unlikely that the Chinese will take such tightening too far and seriously damage the economy’s growth prospects.

Finally, there are a number of significant emerging markets such as Brazil, Turkey, Indonesia and India where Central Banks have actually raised interest rates or have indicated an intention to do.  For the most part, this has been due to currency weakness, which boosts inflationary pressures in these economies, and so a tightening of monetary policy is believed to be required, in contrast to most of the rest of the world.

The league table of the stance of monetary policy, which runs from Japan, the US, the UK, Europe, China and Asia and then other emerging markets correlates precisely with the league table of year-to-date equity market performance.  Those countries with the easiest stance of monetary policy are those whose stock markets have performed best, and those with the tightest policy stance have performed worst.  This highlights the increasing dependence of financial markets on the liquidity provided by Central Banks, rather than fundamental economic and earnings trends.

Looking forward, we would expect Japan to remain at the top of the easy monetary league, with the UK moving up and the US moving down in the next few months, and the Eurozone having little room to make any changes.  China’s slowing growth will eventually produce an easier monetary policy, but may not be imminent, while the other emerging markets appear to be the furthest away from easier policy.  Japan and Asia remain the most favoured markets in our portfolios with Europe and Emerging Markets the least favoured.

Fed up – down with QE?

Ben Bernanke’s discussion of the Fed’s policy intentions in the press conference following the Federal Reserve meeting on June 19 was a shock to markets, with all asset classes around the world falling sharply in response.  His remarks, together with the Fed’s revised economic forecasts for the US, indicate that the policy of QE will begin to be reduced when the unemployment rate falls below 7.5%, and would be stopped altogether when the unemployment rate falls below 7.0%.  Interest rates would only begin to be increased when the unemployment falls below 6.5%.  On the Fed’s economic forecasts, QE would begin to be tapered in September, and end by next summer, with interest rates beginning to be increased in 2015.

Financial markets were very surprised, and for five reasons as follows: (i) the Fed’s latest economic forecasts are optimistic regarding growth and inflation over the next eighteen months  – the Fed expect growth of about 3% over this period, faster than at any time since the crisis, and inflation rebounding to about 2%; (ii) the Fed’s forecasts for growth in 2013 and 2014 are lower now than they were last September when they announced the latest round of QE; (iii) Bernanke has always been very clear that the errors of US economic policy in the 1930s and Japan in the 1990s, following banking crises, lay in the authorities tightening policy too early and before the economies had fully recovered – it was thus expected that he would be slow to reverse QE; (iv) the rest of the global economy is not in a very fit state to cope with this move – Europe remains in recession, the Chinese recovery is not coming through as fast as had been expected, and Japan is just embarking on its own massive round of policy stimulus in an effort to revive its economy; and (v) Bernanke said it was significant that the total amount of QE would still be rising which  indicated easier monetary policy (i.e. lifting the foot off the accelerator) , whereas the markets focussed on the fact that it represented a change in the momentum of QE, and so see it as a tightening of monetary policy (i.e. putting the foot on the brake).

If Bernanke, and the Federal Reserve, are correct in their judgement that US economic growth is about to move higher, then future historians will judge Bernanke very well.  For over five years he has maintained near zero interest rates and extraordinary levels of money creation, which has allowed the US economy to perform better than the other developed economies.  Should the economy accelerate while coping with an ending of QE, as the Fed’s forecasts imply, he would be seen as having exercised tremendous courage during the crisis in adopting QE and tremendous judgement in reversing course and ending QE.

In recent years however the Federal Reserve’s forecasts for growth have been consistently over-optimistic, as the pick-up in consumer and business confidence and spending, which was the objective of QE, has been very slow to materialise.  Seen in this light, discussing the Fed’s policy intentions so openly may be seen as unwise.  If the expected growth acceleration does not occur, the markets have been given an unnecessary and unpleasant surprise, which would make it even more difficult to raise confidence and spending.

There are also other interpretations of the motivation behind Bernanke’s comments.

  1. The most likely is that the behaviour of financial markets in 2013 (up until Bernanke’s comments to Congress on May 22), which saw both bond and equity markets moving steadily higher whether the economic newsflow was positive or negative.  Markets appeared to be responding not to fundamental news but to the provision of liquidity from the QE policy – a feature typical of market bubbles.  By clearly discussing the potential to reduce or end QE, the liquidity support for markets is removed, and any bubble is pricked.
  2. Bernanke’s term as Chairman of the Federal Reserve ends next January 31, and the indications are strong that he will not be seeking to continue.  It may be that he does not want to leave office with a legacy of the most extreme, loose monetary policy that the US has ever employed, and is therefore keen to begin the process of returning policy to more normal settings.
  3. The most bearish (and least likely) interpretation is that he and the Fed no longer believe that the QE policy is capable of delivering growth, but that the risks of the policy, in terms of the scale of the money creation and potential inflation, are now too great.

Some immediate market implications are clear.  Bond investors were happy to continue buying bonds all the time they believed that the Federal Reserve would also be buying them through QE.  From 2003 to 2008, the Asian Central Banks pursued a policy of reinvesting their large trade surpluses into US bonds to prevent their currencies appreciating. From 2009 to now, the Federal Reserve has taken over the role of the lead buyer of US bonds.  The Fed have clearly signalled that they believe this period is near to an end – in the absence of a forced buyer, bond yields are likely to move towards more normal levels.  It will take a much slower economy and a return to QE for bond investors to become confident enough to become buyers again.  This move to higher yields is however likely to slow growth, and lead to lower valuations for all financial assets.

We expect growth not to meet the Fed’s forecasts, and so not trigger the pace of withdrawal of QE that Bernanke set out in the press conference.  Such an outcome is likely however to create confusion and uncertainty in financial markets over the next few months, as investors seek to guess the Fed’s reactions to every piece of news. Bonds are unlikely to perform for some time, and investors should look to reduce positions. Equity markets are not expensive but the outlook for growth is not exciting, except in Japan, and investors should wait for a clearer picture of the global economy to emerge over the summer, before making any significant changes to portfolios