US Fed and other central banks can’t tighten monetary policy much more
Nicholas Spiro says the economic indicators are all showing that monetary tightening won’t be possible for much longer, despite the recent spate of Federal Reserve rate hikes
Ever since the Federal Reserve rattled financial markets in May 2013 by announcing its plans to scale back its programme of quantitative easing, bond investors have been speculating incessantly about the timing and pace of a withdrawal of monetary stimulus by the world’s leading central banks.
The Fed, which raised its benchmark interest rate last month for the sixth time since December 2015 and forecast sharper-than-expected increases in the coming years, is the most advanced in normalising policy.
According to market-derived probabilities of further tightening, the US central bank is almost certain to lift rates another two times this year, with the chances of three more hikes having shot up to 30 per cent, up from 10 per cent at the start of this year.
Such is the extent of the perceived divergence between a hawkish Fed and a much more dovish European Central Bank (which, like its Japanese counterpart, is still pursuing quantitative easing as the euro zone’s underlying inflation rate remains at just half of the 2 per cent target of the ECB) that the spread, or gap, between the yield on 2-year Treasury bonds and its negative-yielding German equivalent has surged to nearly 3 per cent, its highest level since the launch of the euro in 1999.
Yet, while there is little doubt that the Fed will increase rates significantly in the near term, parts of the bond market are signalling that it will jump the gun and be forced to halt its rate-hiking cycle in a couple of years’ time as the US economy slows, possibly forcing the Fed to start loosening policy.
In a striking development which throws the difficulties faced by major central banks in exiting their ultra-accommodative policies into sharp relief, an esoteric indicator in the US debt market is showing that yields will be lower three years from now than they will in two years, suggesting that the Fed will stop tightening policy as early as 2020. In a report which pays particular attention to the inversion of the yield curve in the so-called swaps market, Deutsche Bank proclaims that “the market is [already] pricing rate cuts”.
While it would be wrong to read too much into a single technical indicator, other signs are emerging that central banks will have less room to tighten policy than thought to be the case as recently as the start of this year.
As I have commented on in earlier columns, there is increasing evidence that the global economic cycle has peaked as data releases are no longer beating expectations. Citigroup’s Global Economic Surprise Index, a closely watched gauge that looks at the rate at which data exceeds or falls short of analysts’ estimates, has suddenly dipped into negative territory, dragged down by a marked slowdown in growth in the euro zone.
More tellingly, investors themselves are becoming less optimistic about the global expansion, fearful of the recent escalation in trade tensions. The results of last month’s fund manager survey by Bank of America Merrill Lynch showed that just a net 5 per cent of investors believe global growth will be stronger over the next 12 months – the lowest since June 2016 – while only a net 8 per cent believe corporate earnings will rise, down from 35 per cent in February. As Mint Partners, a London-based brokerage, rightly noted last week, “the phrase of the day is ‘late cycle’”.
This leaves the leading central banks, particularly the Fed, in a bind.
Under pressure to tighten policy in the short term because of a pickup in inflation – market measures of US inflation already exceed the Fed’s target of 2 per cent and are also rising in the euro zone – yet constrained by signs of weaker growth, central banks are in danger of committing serious policy blunders in the coming months.
The International Monetary Fund is acutely sensitive to these risks, pointing out in its Global Financial Stability Report, published last week, that a sharper-than-expected rise in US interest rates due to an “inflation surprise” could backfire as an excessive tightening in global financial conditions “challenges” other central banks, notably the ECB, potentially forcing them to loosen policy once again.
Having spent the last several years anticipating the end of the quantitative easing era, bond markets are now starting to signal that ultra-loose monetary policy will be unwound not with a bang but with a whimper.
The good news is that this may mean monetary policy will stay loose for longer than expected, supporting growth. The bad news is that it may take an overly hawkish Fed, and a nasty market sell-off, to keep policy loose.
Nicholas Spiro is a partner for Lauressa Advisory