2016: major change in monetary policy and more volatility

Published: Jan 2016

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Nearly a decade after the financial crisis, it is pertinent to reflect on how far global markets have come. In doing so, however, one thing is clear: although economies across the world, developed and emerging, all heavily influence one another, they are increasingly out of step.

After the credit crisis, central banks needed to ‘go all out’ across the world in order to stave off depression and return the economy to a normal growth path. Short-term interest rates were cut to almost zero whilst more and more central banks started to create liquidity in one way or another. Often they launched large-scale bond-buying programmes and paid for this with money seemingly plucked out of thin air. Liquidity supply expanded and bond yields fell.

Chart 1: In recent years, a lot of money has been pumped into the global economy


Chart 1: In recent years, a lot of money has been pumped into the global economy

Source: Thomson Reuters Datastream/ECR Research

The credit crisis erupted due to high indebtedness (in the public and private sectors) in many places around the world. A lot of state, business, and household debts were offset by assets such as property and equities. Once the crisis exploded, such assets depreciated in value as the entire credit system threatened to collapse like a house of cards. Central banks tried to increase the value of the assets that served as collateral in order to improve balance sheets. Jobless rates soared in the aftermath of the crisis and wages barely rose or they continued to drop. Consumers did not have sufficient purchasing power to boost economic growth. Therefore, more borrowing appeared to be the only solution. It became necessary to inflate the prices of assets such as real estate, equities, bonds, and so on. The consequences for the financial markets were as follows:

  • Lower interest rates. As a result, investors started to look for returns exceeding government bond yields, which led them to buy risky bonds and similar investments. Credit spreads narrowed and this supported credit growth.
  • Extremely low interest rates, in combination with massive money creation, continued to push up stock prices.
  • Many countries were in exactly the same boat so monetary policies did not diverge much; currency fluctuations were few and far between.

Time for change in the US

But the situation has gradually started to change. The US employment rate has fallen on the back of the aforementioned policies and there is mounting upward pressure on pay. This is a historic moment as once wage increases are rising, consumers will have more buying power. On the basis of past experience, we can expect consumer confidence to pick up as well as borrowing. Spending is bound to improve to the extent that jobless rates fall further as wages continue to rise and purchasing power improves. In combination with the humongous money creation of the past years, this carries inflation risks.

The Fed has now made its first move towards fighting inflation risks. For the first time since the credit crisis, the US raised interest rates to 0.5%. A defining aspect of the situation is that the Fed’s rate hikes are supposed to slow economic growth to the rate of potential (= the sum total of the increase in productivity and workforce growth). In the US, this is just 1.5%-2% whereas up until the credit crisis, growth rates near 3.5% were considered normal. The US is heading for a period when tighter monetary policy – ie less money creation – will combine with rising interest rates and decelerating growth. The bond and equity environment will differ dramatically from what investors have grown accustomed to in the past seven years.

Impacts far and wide

At a time when huge amounts of dollars were being created, many parties in the emerging markets took out loans that were denominated in the US currency. Most of this money was used to build new production units. Upward pressure on US interest rates makes those dollar loans more expensive, and the dollar itself has strengthened. As a result, the dollar debt burden has substantially increased (expressed in the local currencies), while slowing economic growth around the world has resulted in overcapacity.

It is clear that the situation in the developing world is deteriorating. As many of these countries used to be major commodity consumers, the same applies to the commodity producing nations and western industries which are confronted with falling sales as well as lower prices.

The question is how the change will affect the US and other western countries. It shall certainly have a negative impact on manufacturing and especially on trade with the emerging markets. Yet, import prices are falling (lower oil prices are particularly important), which is boosting consumer spending power and thereby the services sector. Such developments could outshine the factors that act as a drag on the economy in the slightly longer term.

Chart 2: Moderate increase in productivity and declining labour force rate mean lower potential growth than in the past

Chart 2: Moderate increase in productivity and declining labour force rate mean lower potential growth than in the past

Source: Thomson Reuters Datastream/ECR Research

Europe faces a different set of circumstances. Although the central bank has applied large-scale monetary stimulus, lending conditions have tightened. The European banks were far more leveraged before the credit crisis than those in the US. Therefore the latter were quick to sell off or write down bad debts. Particularly compared to banks in Europe, which are still focused on improving their balance sheets so are less able to supply credit. Europe has little room to apply fiscal stimulus and jobless rates have risen so much that wage increases are low. Therefore, domestic economic growth is sluggish (specifically, relative to the US) while deflation fears have not disappeared. The ECB has eased its policy from the start of the year – when it expanded its bond-buying programme and imposed negative interest rates – to counter these effects.

What’s more, Europe is increasingly out of step with the US in terms of monetary policy. Such policy divergence has an impact on the exchange rates. This suits Europe well. A cheaper euro is one of very few ways to provide new impulses to the European economy (through improving foreign trade and higher employment).

Global intertwinement

It is impossible to provide a detailed forecast for the monetary situation in each individual country; what happens in one area tends to influence developments elsewhere. We have already seen that the Fed’s tightening bias has serious consequences for the emerging markets. In turn, this will have repercussions for the US economy, which is sensitive to share price movement. Sharp stock market pullbacks will hit the economy hard. Monetary policy divergence between different countries leads to currency fluctuations. This does not matter greatly in good economic times but now that growth is subdued, currency weakness may be a bonus in many places whereas a strong currency can do a lot of damage.

This defines the global economic outlook. US consumers are borrowing and spending more, which has prompted the aforementioned positive economic spiral. The Fed is gearing up for further rate hikes. To paraphrase Ms Yellen, the most fascinating question is the timing of the subsequent rate rises. Yet, tighter Fed policy will set up counterforces that will act as a drag on US economic growth.

Normally, this would provide the central bank with plenty of reason not to raise its key interest rate for the foreseeable future – or at least to limit the rate hikes. Even more so as the listed developments are bound to contain inflation. The irony is that a low rate of inflation will provide consumers with more purchasing power and prevent a growth slowdown. The central bank will have to tread cautiously in any case when tightening its policy. For currency and interest rates markets, this all means 2016 will see more volatility than we saw in the last quarters of 2015.

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