The end of cheap money
Odds are global economy as well as markets will handle rise in interest rates and end of QE, but the bull-run will surely end
We are finally seeing the end of the cycle of cheap money and unconventional monetary policy. The US has already started raising rates, and is about to embark on the long unwinding of quantitative easing (QE), via a shrinking of the Fed’s balance sheet. Interest rates in the UK will rise before year end and the European Central Bank will begin tapering its own QE program any day now. Only in Japan will the central bank continue adding stimulus. Global QE or asset purchases will end (all central banks taken together) on a net basis by Q4 2018.
At first thought, the end of easy money is a frightening prospect. We have had extraordinary monetary conditions since the financial crisis, and many investors have forgotten what normal monetary and interest rate settings look and feel like. Does capital have a cost? The reversal of the monetary cycle is mentioned as the number one risk to global financial markets by most macro investors for 2018. Given the unprecedented and unconventional nature of the monetary accommodation, there is no experience or template as to how markets and the real economy will handle the draining of this monetary stimulus.
While the unwinding of the stimulus can always go wrong, with policy makers overshooting and stressing financial markets, or being too slow and letting inflation take hold, the odds favour a more benign outcome.
The good news about the current tightening cycle is that it is happening in response to a normalisation of economic activity. The global economy is strengthening. Tightening is not being forced by surging inflation. In no major economy is inflation a concern. While there have been times in the past when the world economy has been hampered by higher rates, this was when rates were raised quickly in response to an inflationary surge. In tightening cycles where the inflationary backdrop was benign, the reversal in monetary policy had limited impact on broader economic growth. If this pattern holds the impact on the G-7 economies of the monetary policy reversal should be manageable.
Further comfort can be taken from the fact that we have already taken some steps on the path to policy normalisation, and both markets and the economy, seem to have taken this in their stride.
Markets had an adverse reaction to the Taper Tantrum in 2013, when Ben Bernanke first talked of the Federal Reserve slowing down its purchase of financial assets. Ten-year bond yields spiked from 2 per cent to 3 per cent, and many Emerging Markets came under pressure. The fear was that this would be the template for the market reaction to any talk or sign of a reversal of monetary accommodation, with markets going into a tizzy with every step of policy tightening. However, despite the Fed having gone ahead and raised rates (end 2015) as well as having clearly outlined a timetable for the reversal of QE, markets have been stable. Given that markets are most likely to overreact to the initial signs of a tightening, as positioning has to adjust, we are most probably past the point of maximum risk for markets. The first steps of policy normalisation have passed without a blow-up.
It is also true that the pace of monetary normalisation will be very measured across the globe. The current US tightening cycle has been far more gradual than any prior cycle. Policy makers have no incentive to upset markets. They have gone out of their way to reassure investors that the pace of monetary accommodation removal will not be disruptive. A gradual step-by-step approach to normalisation means that policy will remain accommodative, even as rates are rising due to the starting point.
It is also highly likely that the quantum of tightening will be far smaller than the size of the prior easing. Many investors are convinced that the neutral level of real interest rates has fallen structurally. Combined with the fact that inflation is also unlikely to rise much, this means even the nominal neutral policy rate has fallen structurally. Many economists believe the neutral nominal policy rate in the US and UK is about 2.5 per cent, and 1.5 per cent in the European Union (EU). Given that the current policy rate in the US is at 1-1.25 per cent and zero in the EU, we should not need more than 150 basis points of tightening to reach the new nominal equilibrium rate. Most observers believe the neutral nominal policy rate was about 4.5 per cent pre-crisis.
Just as the policy rate does not need to go back to its pre-crisis level, even the balance sheets of the central banks are unlikely to fully normalise. If one studies the comments made by Mr Bernanke and other central bank leaders, it seems that at most about half of the build-up in central banks’ balance sheets will be reversed. The balance securities will remain on their books, needed for liquidity and financial stability purposes.
While gross debt levels globally are at an all time high, led by government debt, various simulations run by organisations like the BIS, indicate that a modest policy tightening will leave debt costs at still manageable levels. It will not be enough to tip over the real economy.
There are also some benefits to rising rates. Savers get higher returns, which they may be willing to spend, given the feeling of a windfall after a decade of near-zero returns on deposits and low-risk financial instruments. The total amount of liquid deposits held by savers in the EU, US and UK is about $18 trillion. An extra one percent interest on this pool of savings will yield $180 billion in incremental income.
A rise in bond yields also improves the viability of pension funds, with the unfunded portion reducing as bond yields are used to discount future liabilities. This will reduce pressure on companies to continuously inject new capital into these defined benefit schemes.
Higher rates should also incentivise banks to lend, as their margins start to improve.
While there are risks to the normalisation of policy settings, especially given the low base, odds do seem to indicate that the global economy and markets can handle the rise in rates and end of QE. There will be bumps on the road, but the end of cheap money may not be the catalyst to end this global bull market. It seems too obvious a risk and too well telegraphed. This bull-run will end, for sure! The cause of the demise, however, will probably be something no one is thinking about today.