In response to the 2008 financial crisis, major central banks adopted extraordinary measures to stabilize the global system and revive growth. These measures included the maintenance of near-zero interest rates by the Federal Reserve for seven years, and a quintupling of its balance sheet over that period through bond purchases.
This process, known as quantitative easing, was also a key part of policies followed by the Bank of England, the European Central Bank and the Bank of Japan. The latter institutions also reduced deposit rates to negative levels that meant that commercial banks had to pay them to hold their deposits.
Now, there are signals that these central banks may prefer to change policy toward tightening. Whether the planned policy reversals occur would have major implications for investors in global bond and equity markets.
The Fed was the first out of the gate in the tightening process with four increases in the federal funds rate since December 2015 to the current range of 1 percent to 1.25 percent. Even though the Bank of England kept its rate at a record low 0.25 percent after its policy-setting meeting this month, there were three dissents, an unusually high number, from members who sought an immediate increase.
And while the ECB kept its key rate at zero, policy makers upgraded the risk outlook to “broadly balanced,” suggesting that some form of tightening may be ahead. Some investors believe that the bank’s revised risk assessment could be a prelude to an announcement in September that it would start reducing bond purchases that are set to end in December.
Bank of Japan Governor Haruhiko Kuroda and his colleagues decided on June 16 to keep the key rate at negative 0.1 percent and annual asset purchases at 180 trillion yen ($1.6 trillion). However, the central bank’s balance sheet has risen to the equivalent of 109 percent of gross domestic product (for comparison, the U.S. is at 25 percent), and it is starting to own most of the Japanese financial market. This has led to expectations of a reversal of policy.
Despite some steps toward tightening, the four central banks are likely to be cautious. Here’s why a coordinated shift toward a more restrictive monetary policy is not in the cards over the short-term.
The Fed rate hike this month, followed by an upbeat economic assessment by Bill Dudley, president of the Federal Reserve Bank of New York, pushed the two-year Treasury yield to its highest level since March (solid white line, right scale in the chart below). But the 10-year Treasury yield (dotted yellow line, left scale) does not share Dudley’s enthusiasm. At 2.23 percent, it is well below the 2.44 percent at the beginning of the year. Despite Fed Chair Janet Yellen’s hawkish message on June 27, it is just above the 2.21 percent at which it traded at the beginning of June. The Treasury market does not believe that the Fed can significantly tighten further given low expectations for economic growth and inflation.
Another rate increase by the Fed at its policy-setting meeting in September, if it isn’t supported by signs of a stronger economy and a pickup in inflation, risks a further decline in the 10-year yield, even as the two-year yield rises further, narrowing the spread. Historically, a narrowing spread has preceded a slowing economy, which would be negative for corporate earnings and equity prices.
Should overly aggressive Fed action cause the spread to go negative — as it did in late 2006, for example — it could push the economy into recession. The Fed, which has had a poor record of managing policy tightening, would have caused an investor-unfriendly hard landing.
Bank of England Governor Mark Carney is concerned about the negative fallout on the economy and markets from Brexit, and the need to maintain easy policy to partially offset the impact. He followed this month’s meeting of his policy-making body with a public statement that it is still too early to raise interest rates. Addiction to policy easing is hard to end.
Expectations that the ECB would move toward ending bond purchases are not likely to be realized either. The bank’s president, Mario Draghi, indicated at a news conference on June 8 that even though some euro zone economic indicators had turned positive, the ECB was downgrading its inflation expectations for the single-currency area over the next two years. He suggested that this required a continuation of current policies. Although Draghi recognized some reflationary forces in a speech on June 27, he urged prudence in withdrawing ECB support.
The Bank of Japan has also been reluctant to tighten. It justified its maintenance of asset purchases and kept the overnight rate at negative 0.1 percent by pointing to limp inflationary expectations. The 10-year Japanese government bond yield continues at near-zero levels.
The message to markets from the central banks is clear: The monetary feast is unlikely to end soon. Both U.S. Treasuries and European sovereigns should continue to hold value for global investors.