End of monetary easing approaches

Published: May 2015

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Despite many starting the year being sceptical about how effective quantitative easing would be in the Eurozone, more recently, optimism is growing. In this article, ECR explores where Eurozone QE might head next and looks at the possible timeline for a rate hike in the US.

The European Central Bank (ECB) is flooding the system with liquidity. The result: negative interest rates on safe sovereign bonds in the Eurozone, euro weakness, rising share prices, and narrowing credit spreads. By contrast, central banks in the UK and the US have a tightening bias. However, the effect has been limited as interest rates in both countries are comparatively high, so their stock and bond markets attract a lot of capital from the rest of the world, where monetary policy is still loose. For this reason, both the dollar and the pound are expensive.

Market conditions are almost ideal for investors. There is upward pressure on prices everywhere – particularly on share and property prices. But how much longer will this situation last and when will the period of ultra-loose monetary policy end? In a sense, the answer seems simple. Namely, as soon as an upward economic spiral starts up and the deflation risks have disappeared or as soon as it becomes clear that the drawbacks of the current monetary policy outweigh the advantages.

An equally relevant question is: what will happen when the money taps are turned off? Many prices are bound to tumble but as long as the economy as a whole continues to grow, such price drops need not continue for too long. Nevertheless, long-term interest rates will rise substantially in such a climate.

Growth prospects in Europe increasingly positive

Many economists were sceptical about the effectiveness of quantitative easing (QE) in the Eurozone. However, a few months after the ECB started QE, we are seeing more optimism. To start with, bond yields have dropped further than expected. This is because two important European institutions are pursuing totally opposite policies in terms of credit supply. On the one hand, the financial regulators are forcing the banks to shrink their balance sheets and build up capital buffers. Both requirements imply that the banks can only supply limited credit. In addition, to comply with current regulation banks, insurers and pension funds need or want to have a substantial portion of their assets invested in safe government bonds (even if these are loss-making, due to negative interest rates).

On the other hand, the ECB is pulling out all the stops to get credit to ease, as this would be good for growth and ward off deflation. Therefore, the central bank has been pumping huge amounts of money into the financial system to ensure that the banks can lend more – to such an extent that deposit rates have turned negative.

Recent data shows that, by now, minimal interest rates and money creation by the ECB are having a positive effect on lending. On top of this, euro weakness and rising property prices are boosting Eurozone growth (on the back of low interest rates, many investors are buying real estate in anticipation of a handsome profit). In combination with lower oil prices, this explains why the European growth data has recently exceeded expectations. In other words, it appears that the ECB is helping an economy that has already started to improve. This has prompted numerous commentators to recommend an early end to QE. Presently, the ECB maintains that it will stay the course until September 2016, as planned. However, if the data continues to develop positively, this may well be too much of a good thing.

Germany already has full employment and wages are increasing. The current rates of interest are far too low for Germany, whereas the euro is too cheap, which causes growth to accelerate even more. If Germany is to prevent inflation, as well as various other imbalances, it will need a tighter monetary policy in the not too distant future, especially since it will not be possible to offset the disproportionate monetary easing (for Germany) through tight fiscal policy and/or so-called macro prudential measures.

Chart 1: EMU’s economic outlook is better than anticipated. Should the ECB start planning a QE exit strategy already?

Chart 1: EMU’s economic outlook is better than anticipated. Should the ECB start planning a QE exit strategy already?

Source: Thomson Reuters Datastream/ECR

The question is: what will weigh heavier as far as the central bank is concerned? The need to stimulate the weak economies through ultra-loose monetary policy, or the fact that the Eurozone’s strongest economy will weaken unless monetary tightening takes place? It has been said that it would be ‘good news’ for the rest of Europe if the German economy overheats, as this would boost Germany’s export sector. In the short term, this could be true but eventually, imbalances will occur that are bound to undermine the robust German economy. In addition, there is little doubt that rising inflation in Germany will strengthen the anti-Europe movement. If we combine this with the possibility of a Grexit, which could be very costly for Germany – losses of up to €100-€150bn would be conceivable – it is clear that Eurozone tensions could run high.

Considering the pros and cons, our conclusion is that the ECB will probably continue with its current policy but it could yield to German pressure (eg decide to unwind QE earlier) in the autumn. At the same time, we cannot rule out that Eurozone tensions will flare up before that time. Firstly, due to the question whether it is wise to keep Greece in the European Monetary Union (EMU) and subsequently, due to disagreements about adapting the monetary policy to Germany’s needs.

Higher US lending rate a matter of time

The prospects for the US economy are bright. As a result of robust job growth and rising wages, aggregate income has increased and so have asset values, while inflation is low, which is boosting purchasing power. The most likely prognosis seems to be that US economic growth will pick up in the near future. If growth improves, it will only be a matter of time before jobless rates drop so much that wage increases start to rise – leading to an upward economic spiral in the US. We predict an initial Fed rate hike would soon follow.

Currently, the markets are discounting very slow and limited rate hikes in the United States. In all likelihood, the thinking is that as indebtedness is still high (while asset prices could show a knee-jerk reaction to monetary tightening), higher interest rates will soon affect credit supply and economic growth. ECR sees this differently: we expect a rate hike once wage increases are on the rise, which will make the economy better able to cope with rising interest rates. Furthermore, it will attract more capital flows to the US, which will compensate for the adverse effect of the Fed rate hikes.

Chart 2: Taylor rule analysis suggests that Germany needs tighter money while Italian economy needs monetary loosening

Chart 2: Taylor rule analysis suggests that Germany needs tighter money while Italian economy needs monetary loosening

Source: Thomson Reuters Datastream/ECR

Based on the above, we do not think the Fed will be in any real hurry to increase interest rates. In any event, we would expect the Fed to move very slowly at the start of the tightening process. Therefore, initially we do not foresee substantial damage to the financial markets (although a sea change from accommodative to restrictive is too significant to leave the markets cold). Subsequently, conditions in the stock and bond markets could worsen rapidly on rising inflation expectations due to accelerating growth, higher wages, and (overly) loose monetary policy. Higher inflation expectations will put upward pressure on bond yields and fuel speculation on faster Fed rate hikes.

Although, for the coming months, we expect fairly strong downward pressure on long-term interest rates, higher economic growth, rising inflation expectations and tighter Fed policy will result in rising long-term rates later this year. We expect the ten-year EUR swap rate to rise to 1.25% while the ten-year USD swap rate could rise to 2.9% at the end of 2015.

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