A tipping point as monetary policy shifts

In recent weeks, policymakers at each of the US Federal Reserve, Bank of England and ECB have become notably more hawkish. This is a new development as throughout the period 2010-2017 central bank balance sheets have been steadily expanding as the quantitative easing (QE) baton was passed around the globe. With asset prices rising strongly over this period many commentators have been quick to infer that the end of QE signals market trouble ahead. While certainly a headwind, we believe investors should not rush to judgement. There remain many acts to play out in this story before it is finished.

In the US, a reduction in the size of the Fed’s balance sheet is under active discussion. Fed Chair Yellen also recently commented that asset valuations are “somewhat rich” and that the US banking system is now sufficiently robust to withstand a decline in asset prices:

“…asset prices can move, they can cause losses to individuals who decided to invest in things that fall in price but we’re worried about systemic risk and with a strong banking system…those kind of repercussions are not top of my list.”

Taken together with Fed Vice Chairman Fischer’s observations that markets have in part been driven higher by increased risk appetite and that close monitoring is warranted, investors have been warned twice in recent days that the Fed believes risk premia are currently too low.

At the BOE, a relatively tight vote on interest rates this month surprised markets. Governor Mark Carney initially indicated after the meeting that in his view now was not yet the time to tighten policy. However, this week he conditioned his view on the outlook for UK business investment, which if firm could mean “some removal of monetary stimulus is likely to become necessary”, thus significantly clouding the picture.

ECB President Draghi has also suggested that to keep the stance of monetary policy constant as the eurozone economy improves, policy should be dynamically tightened. Draghi’s comments in particular seem to have pushed markets over a tipping point; although his speech in Portugal was in our view anodyne it has triggered one of the sharpest daily increases in global bond yields for a number of years. In fact Reuters reported shortly afterwards, quoting sources within the ECB, that the comments had been misinterpreted. However, with three of the world’s most influential central banks taking, or being perceived to take, a more hawkish tack the scope for an air pocket in global equities has clearly increased.

Exhibit 1: Central bank balance sheet expansion 2010-2017

The impact of central banks’ purchasing of government bonds in recent years on asset markets should also not be underestimated. With total assets of the world’s major central banks close to US$14trn, central banks have absorbed over 25% of the value of developed market government bond markets. This has pushed government bond yields lower and, combined with forward guidance on interest rates, lowered the discount rate and risk premium on a wide variety of riskier assets, including corporate bonds and equities. The policy has also significantly reduced sovereign funding costs and not just in the periphery of Europe.

Now, there is increasing concern in the market about the transition to market-determined government bond yields over the course of 2018-2019. The most obvious implication is that a return to higher market-based yields implies higher discount rates for other assets. It is difficult to argue this point. For example, a wholly unanticipated increase in real rates of only 1% would, all other things being equal, imply a significant decline in the fair value of developed market equities.

However, such an increase is already partly discounted. US Fed Chair Yellen has been as clear as she can be on the slowly rising trajectory of the neutral interest rate. Furthermore, all other things are unlikely to be equal. In a scenario of higher real rates, growth would be stronger, offsetting the impact.

Therefore, we could rewrite the assumption that the end of QE and start of monetary tightening will necessarily lead to a major market crash as an assumption that the world’s monetary policymakers will necessarily make an enormous policy error. While certainly a non-zero probability, it would require additional constraints on policy to make it a base case.

Most obviously, should the US economy slow through Q3 the US Fed is fully at liberty to change its view on both the appropriate level of its balance sheet and the trajectory of interest rates. The ECB is also able to change course even if it is running into constraints in terms of eligible securities for balance sheet expansion. It is easy to forget that just as the ultimate extent of global QE was wholly underestimated by the market several years ago, forecasts for quantitative tightening are equally subject to a high degree of uncertainty.

However, a dangerous constraint would be rapidly rising or significantly above-target inflation. Fortunately there is little evidence of this at present, with the exception perhaps of the UK. What may be closer to policymakers’ thoughts however is that even as the US Fed has raised rates, broader financial conditions (including measures of credit and equity risk premia) have eased over the last 6 months. For the eurozone, where monetary policy has been targeted at reducing financial risk premia, there is a growing feeling of mission accomplished.

Policymakers at present seem to fear getting behind the curve. According to Draghi, rising asset prices and improving business confidence would justify a tightening trajectory of monetary policy just to maintain a steady level of policy accommodation.

We believe central banks’ recent change of tack (or even just change of emphasis) adds weight to our prior views that investors should proceed cautiously at present. However, there is a distinction between headwinds and hurricanes; we do not believe policy error should be the base case at this stage. To date, comments from policymakers do not by any means indicate that a policy error is inevitable but they are instead a shot across the bows of the market, aiming to lower the risk of financial instability and mal-investment.