The world is changing fast and to keep up you need local knowledge with global context.
By Derry Pickford and Mark Appleton*
For most of the history of the Euro, the Fed and the ECB’s interest rates policies have largely been in sync. Once the Fed started hiking or cutting the ECB would soon follow suit. It would be rare for monetary policy to be moving in opposite directions, but Chart 1 shows that is exactly what is happening now.
Since the Fed stopped asset purchases, the ECB and the BoJ have indicated a highly stimulative stance for 2015. We believe that the ECB should increase its balance sheet by around e600bn over 2015; around 6% of Eurozone GDP or just under 1% of world GDP. Together with the 80 trillion Yen in BoJ purchases announced at the end of October (16.5% of Japanese GDP and just under 0.9% of World GDP), this is more, as a proportion of world GDP than the rate at which the Fed grew its balance sheet in 2013 with QE3 at full pace.
China also looks set to loosen policy further next year. China watchers had been pondering all year whether, in the face of falling property prices and slowing industrial production, China was about to cut rates. Then, just as markets were coming to the conclusion that any big change in policy would have to wait until next year, the People’s Bank of China (PBoC) decided to cut the one year benchmark lending rate by 40bps to 5.60% p.a. (one year deposit rates were lowered by 25bps to 2.75%). With both producer and consumer inflation below the PBoC’s (unofficial) comfort level rates it seems likely that rates have further to fall next year with the possibility of being supplemented by reserve requirement ratio (RRR) cuts. A cut to the RRR will reduce the proportion of deposits that Chinese banks have to lodge at the PBoC and could do more to incentivise the banks to lend than asymmetric interest rate cuts will.
There remains some divergence amongst monetary cycles within emerging markets. Whilst a few countries such as South Africa, Brazil, Russia and Nigeria are hiking, partly in the face of weakening currencies, others such as South Korea, Poland and Chile have been cutting rates in the last few months. With oil prices falling and global inflationary pressures subsiding, it seems likely that other countries will start cutting next year too. India in particular should start to enjoy the benefits of a much lower global oil price plus the huge increase in credibility that Governor Rajan has created since he joined the RBI last year.
Implications for currencies, bond yields and equities:
Central bank balance sheet expansion typically has a weakening effect on the underlying currency of that country. We know that Europe and Japan are on that monetary expansion path and hence it would be surprising if those respective underlying currencies did not have a weakening bias. Conversely the US Fed has halted its own balance sheet expansion and this should prove supportive of the Dollar. Of course what happens in one part of the world has an impact on what happens in another. The deflationary impulse most in Europe is likely to keep rates low in the rest of the world too. The German bund yield at 0.72% makes the 10 year US Treasury at 2.27% relatively attractive creating demand for US Treasuries and consequently the USD. The near 10% US Dollar trade weighted appreciation since the summer is likely to have a slight dampening effect on US inflation and exports. This in turn may influence the Fed in its timing of the initiation of the interest rate tightening cycle.
While a lack of demand growth globally may be concerning from a corporate earnings growth perspective, valuations appear to be well supported by low risk free rates. Forward earnings yields are above 6% in most markets and as such, equities remain the asset class of choice.
When it comes to monetary policy will the UK follow the Fed or the rest of the world? It is now nearly six months since the House of Commons’ Treasury Select Committee accused Bank of England Governor, Mark Carney, of being like an “unreliable boyfriend”, for “blowing hot and cold” on the question of rate hikes. Yet despite being lambasted for a lack of consistency, the tone of Bank of England communications has shifted yet again with options markets now suggesting that by the summer of 2016 rates will be little higher than they are today.
This is not entirely the Bank of England’s fault. The ECB has been slow to respond to the anaemic growth in the Eurozone which has had a knock-on impact on the UK. Political headwinds have also not helped. The fallout from the Scottish independence referendum, a General Election in May next year, and a potential referendum on the UK’s membership of the European Union has created uncertainty. The UK’s property market has also slowed rapidly as banks have become more cautious about lending criteria, as bubble concerns grew. Concerns about the introduction of new property taxes should Labour win the general election have also stalled the upper end of the market. Foreign property purchasers in luxury London property had been an important source of demand. Even if the UK joins the Fed and starts hiking at the end of 2015, these concerns are likely to persist as an overhang on Sterling next year. The USD looks set to remain the major currency of choice.
1The exception being in July 2008 when the ECB hiked one last time even though the Fed had been aggressively cutting since the summer of 2007.
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