After a number of starts and pauses, central banks across the world seem to be starting the process of scaling back the extraordinary measures that have dominated the global market since the global financial crisis. Let’s try to see how the central bankers can win the battle in this economic cycle.
Nearly a decade ago, global crisis swept across the markets and as the “Great Recession” engulfed the world, central banks took some unprecedented measures in an attempt to save the financial system. Monetary policy was changed to an extraordinary version of itself as quantitative easing was introduced and interest rates were cut into negative territory. As the entire investor world looked upon, some with hope while others with terror, the old rules of finance were rapidly rewritten.
As growth is returning to the world, new monetary policy awakens.
The Fed is once again leading the pack of developed market central banks in gradually reversing its accommodative policies. They did this by first announcing the tapering of quantitative easing in December 2013 and officially ended its monthly asset purchases program in October 2014. Next, after about a year, December 2015 saw the first hike from the Fed since June 2006. The Fed has gradually raised interest rates since then taking the fed funds rate from a range of 0 – 0.25% to 1 – 1.25%. More recently, the Fed announced that it will stop reinvesting the principal of securities when they mature in an attempt to shrink its balance sheet.
The European Central Bank (ECB) is following suit if not in hiking rates in the near future, then at least in tapering its asset purchases. While Mario Draghi has been an enthusiastic user of quantitative easing, buying assets on a tremendous scale (see chart below), the ECB is running out of bonds to buy. Mark Carney from the Bank of England has been active as well, dropping the base rate in the crisis and then again after the Brexit vote. He has indicated that rates will rise, but we wait to see how Brexit plays out. He is expected to leave just before the UK breaks from the European Union, but will he do something in a hurry and commit a mistake? Only time will tell.
The Bank of Japan’s (BoJ) use of monetary policy has been interesting, and Governor Kuroda has been an advocate of keeping policy rates at record lows. He has been the most innovative of the central bankers taking unprecedented decisions such as yield curve control. In step with the other global central banks across the world, the BoJ has sparked speculation that it may wind back its monetary stimulus by trimming the amount of its purchases of Japanese government bonds.
As the four central bankers are set to retire soon, the future of monetary policies and central bank decisions could be in uncertain territory highlighted by the discrepancy between what the market is pricing and what central bankers are officially saying. The last one to normalize policy could be either Kuroda or Draghi.
There is a possibility that Jerome Powell – Janet Yellen’s successor as Federal Reserve chairperson – could change course, though we believe he will aim to follow Yellen in making the right decisions to normalize interest rates. Carney seems to be the most susceptible with the uncertainty of Brexit and the risk of the UK economy crashing. Europe still needs support as it struggles with the complexities of multiple individual economies. Japan has been battling deflation for a long time and their use of unconventional monetary policy for so long will make it difficult for them to let go of the clutch of yield curve control.
Quantitative easing could be a tool with a double edged sword. The Fed has started to reduce its balance sheet and the European Central Bank as well as Bank of Japan are persisting with their programs at a slower pace. Hence, central banks are expected to switch from expansion to contraction in 2018. We will need to monitor the market reaction as the central banks remove their support and their impact on asset prices. If all does not go as per plan, the central banks could well turn out to be villains in disguise.
It is important to stay active in this environment – fixed income performs an important role to preserve and protect capital as well as provide a stable source of income. However, investors who feel the policies no longer support fixed income due to lower current yields are missing the end game and could eventually lose out on the benefits of diversification.
An actively managed portfolio possesses all of the above qualities with the ability to diversify across the fixed income universe as well as dynamically allocate exposure as the market warrants.