Author: Daniel Murray, CFA, Deputy CIO and Global Head of Research at EFG.
Should the divergence now opening between the monetary policies of the world’s major central banks matter for markets? Daniel Murray, CFA, provides some analysis on how monetary policy will impact financial markets.
The US Federal Reserve has hiked rates seven times since the tightening process began in December 2015 and is expected to hike further both this year and next. If current market expectations prove accurate, the Fed funds target rate (upper bound) will finish 2019 some 3% higher than the 2015 lows.
By the standards of historic hiking cycles, the pace of US tightening is slow, yet compared with the behaviour of other major central banks the Fed is positively hawkish. It is true the Bank of England raised Bank rate by 25 basis points in October last year, though this may be viewed as the removal of emergency stimulus that was applied following the vote to leave the EU. Further hikes in Bank rate are expected to take place once a year for the next three years according to the Bank’s own forecasts. In contrast, the ECB and Bank of Japan are committed to maintaining policy rates at their current levels for the time being. The ECB has announced that it will wait until “at least through the summer of 2019” before hiking interest rates, although it has also indicated that it intends to stop asset purchases by year end.
This helpfully highlights the other dimension of monetary policy central bankers need to consider, namely the process of balance sheet normalisation. The unprecedented balance sheet expansion that took place during and following the financial crisis that began 10 years ago is still largely in place. The Fed started to shrink its balance sheet in October, albeit at a gentle pace. This contrasts with other major central banks, as shown in Table 1. It is interesting to note that a greater degree of divergence is now opening up between the monetary policies of the world's major central banks, reflecting the order in which economies emerged from the crisis.
Table 1. Central Bank Policy Comparison
| Balance Sheet | Policy Rate | |
| Fed | Shrinking | Increasing |
| BoE | Stable | Increasing (slowly) |
| ECB | Expanding but expected to stop | Stable |
| BoJ | Expanding at same rate | Stable |
The question we should ask is whether any of this matters for markets. The answer is “a little bit but not very much”. One observation is that equity markets tend to rally during the first part of the hiking cycle. An interpretation of this is that when activity starts to improve a high degree of uncertainty remains regarding the durability and robustness of the expansion. Central bankers are understandably cautious during such periods so are reluctant to tighten policy too aggressively. This means real rates stay lower for longer; it is only once the expansion is well entrenched that policy makers feel sufficiently confident to tighten more forcefully. In this cycle, normal central bank reluctance to tighten too quickly has been exacerbated by unusually benign inflationary pressures, despite exceptionally low unemployment rates – and it is worth remembering that most central banks have a legal mandate referenced against inflation. Real interest rates are thus very low – in some cases negative - and are expected to remain so for some time.
Shrinking Balance Sheets
Another observation relates to the potential impact of changing central bank balance sheets. Last year the four central banks highlighted above expanded their balance sheets jointly by around $2.5 trillion; this year's net expansion will be around $0.6 trillion, even though the Fed's balance sheet will shrink. It will not be before 2019 at the earliest that central bank balance sheets experience joint net diminution. If the Fed manages to shrink its balance sheet at the maximum announced rate, that will amount to a reduction of $420 billion in 2018, of which $252 billion will have come about through reduced US Treasury ownership. Meta-analysis of empirical estimates suggests that every $100 billion of Fed asset purchases pushed the yield on the ten year US Treasury bond about 5 basis points lower than it might otherwise have been. Reversing those estimates therefore suggests Fed balance sheet shrinkage might result in the ten-year Treasury yield being 12.5-20 basis points higher than it might otherwise have been. In the whole scheme of things this is relatively modest and hard to distinguish from normal -market volatility - the average weekly absolute yield change in the ten year Treasury has been around 7-10 basis points over the past five years.
Recessions are almost always preceded by a tightening of monetary policy and are almost always associated with stock market sell offs. Yet the sluggish pace of central bank rate hikes together with ongoing low real rates suggests the next recession is some way off. Ongoing aggregate central bank balance sheet expansion in 2018 will provide less support for financial markets than in 2017 but will nonetheless continue to be a tailwind. The exception is in the US where Treasury yields might move marginally higher, though it will be hard to distinguish for some time between the impact of Fed balance sheet shrinkage and that which would have occurred anyway.