With the Fed ending QE, many commentators remarked that the greatest monetary experiment in history is ending. Not quite. A couple of days after the FOMC meeting, the BoJ stepped up its own monetary easing programme. In addition, the ECB is still implementing stimulus and will likely also extend its asset purchases, though probably not this week and likely towards other securities than government bonds. This means that global liquidity does not dry up with the Fed’s last taper. In addition, there are consequences for currencies, with the yen and euro likely to weaken further against the dollar. Meanwhile, economic data was generally good this week, supporting our constructive view on the global economy.
Past rate hike cycles suggest the economy continues to do well.
Nick Kounis Head of Macro Research
The Fed’s last taper
As was widely expected, the Federal Reserve ended its asset purchase programmes altogether after the FOMC meeting earlier this week. Following a gradual tapering at previous meetings, the monthly size of asset purchases had already been brought down to USD 15bn from the high of USD 85bn seen during 2013. In its statement it continued to signal that a rate rise was not imminent, saying that interest rates would remain on hold for a ‘considerable period’. Having said that, its positive view of the labour market and economy suggest interest rates would likely rise during the course of next year. The FOMC judged that labour market slack was ‘diminishing’ and continued to see ‘underlying strength’ in the economy. We expect the Fed to raise interest rates from the middle of next year, which also seems consistent with the central bank’s signals. Financial markets still have to catch up with this view, as they are only factoring in one rate hike at the end of next year. Still, we do not think that gradual interest rate increases should be a major problem for the economy or markets. Past rate hike cycles suggest the economy continues to do well, and with inflation subdued the Fed will be able to withdraw stimulus at a pace that the economy can cope with.
The great monetary policy experiment…
The Fed’s monetary easing programme has been extraordinary. Its balance sheet has risen to almost 4.5 trillion dollars, compared to less than one trillion before the financial crisis. The debate about whether it was a success will probably continue to run for years to come. Overall, we think that it has had a positive impact. The first asset purchase programme late in 2008 was particularly effective in unblocking the financial system and reviving investor risk appetite. If the Fed had not taken those actions back then, the world may have looked very different. Although we still had a major recession, it was not a 1930s-style depression. The subsequent programmes were not quite as decisive but do look to have supported the US economy via easier financial conditions, including a weaker dollar, during a period of balance sheet repair. The Fed still needs to get its own balance sheet back down to normal levels. It will likely do this gradually by allowing assets to mature and stopping to re-invest the proceeds. In the meantime, it will use new tools to manage the liquidity in the system. All this is not without risks but the consequences of not acting were surely bigger.
BoJ steps up monetary easing
The big monetary experiment is not over yet. The BoJ has been aggressively easing monetary policy by buying Japanese government bonds and other assets. On Friday, it surprised financial markets by stepping up its monetary easing programme. It will now buy around 80 trillion yen of assets a year, compared to 60-70 trillion before. This is significant even in global terms. It equates to monthly asset purchases of around USD 60bn. This is not that far off the pace of the Fed’s programme last year, even though the Japanese economy is much smaller. The BoJ’s actions reflect its determination to get rid of deflation once and for all. Although inflation has returned, it remains low. In addition, the economy has weakened following an increase in the sales tax in April.
ECB likely to follow in coming months
The BoJ is not the only major central bank still in easing mode. The ECB is still rolling out the measures it announced in June and September. It has already started buying covered bonds. In the first three days of the operation, it bought EUR 1.7bn worth, which is more aggressive than during its previous covered bond programmes. We do not expect it to maintain this pace given the size of that market and limited net supply, but the programme still has a long way to go. In addition, the ECB still has to begin its ABS buys, while its second of eight TLTROs (providing cheap and long-term funding for banks) is set for next month. In addition, we think that the ECB will likely do more. Although we think that the economy is still on track for a moderate recovery, data over recent months has been disappointing. In addition, the fall in oil prices is likely to keep inflation at very low levels in the coming months. Inflation rose to 0.4% yoy in October from 0.3% in September, but will probably stay at or below 0.5% in the immediate future. Although the fall in the euro should eventually push up inflation during the course of next year, it will remain subdued. We think the risk of deflation is small, but extended periods of very low inflation are also not acceptable. The ECB’s job is to keep inflation on track to reach 2% over the coming years.
Agency debt and corporate bonds more likely than sovereigns
The big question is what the ECB will do. The Fed and the BoJ focused their easing on government bonds. However, the hurdle for the ECB to follow that path is high because of strong opposition from Germany. Meanwhile, buying unsecured bank bonds may not be a great idea given the central bank’s new supervisory role (however big the walls between the different departments). That leaves two significant markets. One is debt securities issues by eurozone-level bodies such as the European Investment Bank. The debt of sub-sovereign agencies in individual countries may also be an option. In addition, non-financial corporate bonds could be purchased. We think that this week’s meeting is too early for the ECB to act given its still has not even started its ABS programme and may also want to wait for more economic data. However, we think that we could see further action in December or January.
Passing the baton
Overall then, the Fed’s end of QE does not signal the end of global monetary easing, but the passing of the baton to the BoJ and the ECB. This means that plenty of liquidity will remain available in the global financial system. The expansion of the ECB and BoJ balance sheets combined going forward will probably exceed the Fed’s, even at its fast pace of last year. This picture provided strong support to equity markets following the BoJ’s surprise announcement. The other major consequence of the passing of the baton that we are seeing is further weakness in the euro and the yen versus the dollar. At a global level, currency shifts are a zero sum game, but it does makes sense in terms of balance that weaker economies with very low inflation have weaker exchange rates.
Data support constructive view of the global economy
The positive mood on markets is not just a liquidity story. The gloomy narrative of global growth that undermined investor sentiment earlier this month has been severely challenged by evidence from the ground. Economic data was generally positive this week. US GDP expanded by 3.5% in Q3, which was better than the 3% consensus estimate of economists. Some of the details of the report were less encouraging than the headline. For instance, growth was boosted by volatile defense spending. In addition, investment and consumer spending were nothing to write home about. On the other hand, another volatile item – inventories – subtracted from growth. In addition, the components of GDP can be quite volatile in any case. Judging by the surge in consumer confidence in October, consumer spending is likely to re-accelerate before long. Meanwhile, the Chicago manufacturing PMI surged to 66.2 this month from 60.5 in September. The bottom line is that US economy registered its second successive quarter of well above trend growth and early evidence from the fourth quarter suggests this will continue.
Eurozone data flow more positive
There was a batch of generally more encouraging eurozone economic reports this week. The European Commission’s eurozone economic sentiment indicator rose to 100.7 in October from 99.9 in September, which was well above the consensus forecast of 99.7. This took the indicator above its long-term average of around 100 and to levels consistent with moderate economic growth. Meanwhile, German unemployment fell by 22K in October after a 9K rise in September. This leaves it on a moderate downward trend in line with evidence that the upswing in employment is continuing. Furthermore, early Q3 GDP data from Spain (+0.5% qoq following +0.6% in Q2) and Belgium (0.2% from 0.1%) pointed to ongoing expansion. Finally, there was also good news from the ECB’s bank lending survey, which showed that the demand for loans continued to rise, while banks also further eased credit conditions in Q3. Not all the data has been positive. For instance, Germany’s Ifo business climate indicator fell significantly further in October, in contrast to the PMI data for the country, which actually rose quite convincingly. In addition, German retail sales plunged in September, though these data tend to be volatile. Overall, we are starting to see a better tone for eurozone data ending a period in which negative economic surprises were very dominant. We continue to think that a moderate economic recovery is on the cards.