- Fed hike represents “small but significant” step
- Markets are underestimating pace of US rate rises
- We concede there are risks to this view should financial market turbulence persist
- Policy divergence to remain a key theme for some time
The Federal Reserve began ‘normalising’ monetary policy in December, highlighting just how far the economic fortunes of the US have diverged from those of most other developed market economies since the global financial crisis, writes Michael Grady.
After a couple of false starts earlier in 2015, the US central bank finally put an end to the ‘will they, won’t they’ speculation gripping markets by hiking rates in December. It was a small but significant step coming almost eight years after the start of the global financial crisis. It also signalled the arrival of a much-anticipated theme in global capital markets: monetary policy divergence.
Prior to 2008, divergence in monetary policy across regions was not uncommon, with US and European policy rates differing by two per cent or more. But this was usually characterised by one side either hiking or cutting more quickly than the other. It was far less common to have policy moving in opposite directions.
This is the situation now, with the Federal Reserve (Fed) raising rates while the European Central Bank (ECB) continues to loosen policy. In December, the ECB reduced its key policy rate further into negative territory and announced the continuation of quantitative easing – comprising €60 billion of European government bond purchases a month – until at least March 2017, and potentially beyond then.
The ECB is not alone in easing monetary policy. At least six other major central banks, including the Bank of Japan and the People’s Bank of China, are in easing mode. Fewer in number are potential candidates to follow the Fed’s lead in the short-term. The Bank of England is widely expected to hike later this year or early next, although uncertainty created by the upcoming referendum on whether Britain should stay in the European Union makes the timing of any move unclear.
Is this time different?
So what sets the US apart from other countries whose central banks are easing, and what does it mean for the policy outlook both in the US and elsewhere, as well as key investment markets?
The global economy emerged from the 2008 financial crisis at a slow pace. In prior decades, recessions tended to be relatively short-lived, monetary policy was eased aggressively and the resulting recoveries were rapid enough to bring output back to the previously implied trend path within a few years. This time has been different. The synchronised nature of the global recession, driven by a sharp financial contraction, increased the likelihood that permanent, or at least long-lasting, damage would be inflicted.
The slow pace of recovery should not surprise. In a paper published in 2014, US economists Carmen Reinhart and Kenneth Rogoff examined 100 financial crises since the late 1800s and found that it took, on average, nearly eight years for economic output to recover to the pre-crisis level1. By contrast, it took the US around four years to recover to the previous peak following the global financial crisis.
The steady recovery in the US has seen growth average around 2.25% since 2010, well below pre-crisis levels. However, that rate of growth has been sufficient to drive unemployment down to 5%, from a peak of 10% in 2009. While continued weakness in the labour force participation rate is partly to blame, the vast majority reflects a reduction in spare capacity, or economic slack.
To achieve this outcome, the Federal Reserve has needed to keep the policy rate at effectively zero and undertake sizable purchases of US government bonds and government-backed mortgage debt. Headwinds to the US recovery, including tighter fiscal policy and credit conditions, household balance sheet repair and slower global growth have arguably lowered the equilibrium or ‘neutral’ real interest rate. As the economy continues to recover, and as these headwinds abate, that neutral rate should begin rising. While the pace and level of rate hikes is likely to be modest relative to previous cycles, the Fed’s decision to begin tightening policy in December was driven by a desire to keep inflation close to its target in the years ahead.
The median view of the Federal Open Market Committee is that it will raise rates by around 100bp over the course of 2016, and by a similar amount again in 2017. This would be around half as fast as the previous slowest hiking cycle by the Fed. Following the recent bout of turmoil, the market is currently pricing in an even slower pace of hikes, of less than 50bp in each of the next two years. Since we are more inclined to the Fed’s view, we believe there is an opportunity to profit from a faster rise in rates than the market expects. Nevertheless, we concede there is a risk rates won’t rise this fast, particularly if the financial market instability seen since the start of the year continues.
The combination of uncertainty around Chinese economic growth and policy, alongside a further decline in oil prices, may cause the Fed to pause a little longer before hiking again. But could the Fed be forced to completely reverse course? There are precedents from the past few years, with a number of central banks in developed countries raising rates after the crisis, only to be subsequently forced to retreat.
However, they were small open economies, subjected to significant external shocks. The US on the other hand, is a large, relatively closed economy with domestic factors dominating. As such, a scenario where external factors could lead the Fed to reverse course would involve a steep contraction in global growth; with a hard landing in China the most likely source. While not beyond the realms of possibility, the macroeconomic picture would have to deteriorate considerably from this point.
Taking it easy
Elsewhere, the recovery has been slower and more variable. The euro area suffered a critical aftershock from the global financial crisis in the form of the sovereign debt crisis that emerged in 2010. While real activity in the US is now nearly 10% higher than its pre-crisis level, in the euro area it remains slightly below the pre-crisis peak, a full eight years down the track.
Although the risk of a euro area break-up has greatly receded since Mario Draghi’s “whatever it takes” speech in summer of 2012, the tepid recovery, alongside very low inflation, has led the ECB to ease policy increasingly aggressively. While we expect inflation to pick up slowly over 2016, there are significant risks to the downside. They include the aforementioned risks in China and other emerging countries, as well as the threat that weaker commodity prices further depress inflation. If the threat of deflation persists, the ECB may be forced into taking further action later this year in order to prevent a de-anchoring of inflation expectations. That would put further downward pressure on the euro, particularly if the Fed were to tighten policy in the way we anticipate.
In Asia, the Bank of Japan (BoJ) continues to pursue looser policy. After several failed attempts in 1990s and 2000s to raise inflation expectations, the second coming of Shinzo Abe as Japan’s prime minister was a pivotal moment; with monetary easing one of the “three arrows” of so-called Abenomics. Soon after Abe’s election in December 2012, the BoJ said it would purchase ¥60 to ¥70 trillion of government bonds a year. It upped the ante in October 2014, by increasing annual purchases to ¥80 trillion and saying it would buy bonds for longer. While there has been a modicum of success, the BoJ will likely have to ease policy again this year in order to weaken the yen and boost inflation towards its 2% target.
China, meanwhile, is experiencing slower and more uneven growth as the country struggles to transition its economy towards consumption and away from investment. While the People’s Bank of China (PBOC) has eased policy to support that shift, it is arguable whether further measures to fuel credit growth are desirable.
More contentiously, recent changes to the country’s exchange-rate regime have resulted in a notable depreciation in the renminbi against the US dollar. While the absolute magnitude of that adjustment has been modest so far, the global market reaction has been more acute; likely reflecting concerns about both the depth of the slowdown and the ability of Chinese policymakers to manage it. We expect the PBOC will allow a further moderate depreciation against the dollar this year, as capital outflows remain large. But it will continue to make use of its vast foreign exchange reserves to prevent speculators pushing the currency down too quickly.
You can go your own way
What marks out the policy outlook for these central banks are the particular needs of their own nation’s economy. The US economy, for example, has reached the point where a gradual tightening in policy is required to ensure that the quest for full employment does not come at the cost of excess inflation. In that respect, it is important to recognise that while headline inflation rates around the world are extremely low – close to zero in many countries – this reflects the temporary impact of lower oil prices. Unless we see further sharp declines, this effect will begin to wane in 2016. In the US, core CPI inflation has been rising and is already running close to the Fed’s 2% objective. That compares to a more stable core rate in the euro area of just 0.9%.
The uneven global recovery will make policy divergence a key theme for some time. The central banks that are still easing policy are a long way off from the start of their next tightening cycle. For example, the policy divergence between the US and the euro area will likely persist over the coming years, with interest-rate differentials rising to the widest in over a decade. In this scenario, we would expect to see the spread between US treasuries and European government bonds widen further. In terms of the currency implications, we expect the US dollar to rise further against the euro. The dollar should also strengthen again the yen and the currencies of commodity exporting nations such as Australia, Canada, Brazil and South Africa.
Policy divergence also has implications for equities. It leads us to favour markets where valuations are not stretched and aggressive monetary easing is likely to continue. The recent market sell-off provides an opportunity to buy European and Japanese equities at attractive levels. Both markets have suffered in relative terms and look attractive compared to US stocks.