From negative policy rates to yield curve control – what’s next?
The Bank of Japan did it again: just when market participants had become familiar with quantitative easing and negative interest rates, it surprised with its latest monetary experiment: ‘yield curve control’. A powerful answer to those claiming that the toolbox of central banks looks empty or a clear sign of ‘policy exhaustion’?
The move is not totally unprecedented. A comparable approach was adopted by the Fed after World War II. The aim of the US government and the Fed was to avoid another depression and to accommodate employment creation (Employment Act of 1946). Official interest rates were kept close to zero and the Fed continued the war-time policy of purchasing Treasury bonds, keeping long-term interest rates below 2.5%. Between 1953 and 1960, the Fed gradually ceased intervening in the pricing of longer term Treasury bonds as inflation moved higher.
Under the new regime the BoJ will not only target short-term policy interest rates, but also 10-year yield levels. In doing so it can enforce a steeper yield curve, which is supportive for the banking sector. It can also be regarded as an open invitation to the Abe government to boost fiscal spending. If the additional issuance of government bonds were to push up yields, the central bank now has the flexibility to intervene in the market.
Does it pave the way for full-blown helicopter money? In the absence of a significant financial market or economic crisis, we don’t think so. However, the new framework does bring the BoJ a lot in terms of flexibility, sustainability and, perhaps at at some stage, credibility of its policy. In our view it is quite possible that the monetary authority will opt for more rate cuts now that it has the tools to keep the shape of the curve stable. We might not have seen the lows in the country’s yield levels after all.
Japan can be regarded as the world’s laboratory for unconventional monetary policy. Already for this reason it is important to monitor developments closely. Almost every advanced economy is faced with the same economic challenges such as low productivity growth, rapid population ageing and elevated public debt ratios. Only in the case of Japan the urgency to face these challenges appears to be higher. A global policy shift away from monetary expansion and a comeback of fiscal expansionary policies could very well start in Japan.
Our key theme: Low growth, low inflation
We see no reason to deviate from our base case scenario for the global economy, which centres around low growth and low inflation. Political risk in advanced economies is on the rise. Policy uncertainty will increase with the US elections in November and the constitutional Italian referendum in December. Next year, elections are scheduled in many European countries. Early 2017, Brexit negotiations will officially start, which could give rise to more uncertainty. The recovery in commodity markets is supportive for emerging economies and in many countries falling inflation is allowing central banks to ease monetary policy. Imminent worries on the Chinese economic outlook have come down, but long-term challenges and risks remain.
Emerging (local) debt has further to go
A global economy that is neither overheating nor on the brink of a recession, is a favourable macro environment for the asset category. In a low growth, low inflation world the Fed will not normalize official target rates aggressively. Part of the global liquidity flood other central banks (Bank of Japan, Bank of England and European Central Bank) are providing is finding its way to emerging markets. Investor flows confirm this improving technical backdrop.
From a valuation perspective local debt looks appealing. Many central banks have tightened policy in recent years to defend their currencies. This has driven up real yields levels across the universe. As core yields moved lower, the yield differential with developed markets increased in recent years. This year, most currencies have appreciated versus both the US dollar and the euro, but they are by no means back at pre-taper 2013 levels. The fundamental outlook for most countries remains the weak spot, but even here in some cases cautious optimism looks warranted.
No value in front end US yield curve
Money market future contracts show that rate hike expectations for the US Fed have come down a lot. Between one and two rate hikes are now being discounted for the coming two years. The Fed recently confirmed this very gradual normalization trajectory when it updated its ‘dot plot’, which shows the projections of the 16 members of the FOMC. From a valuation perspective we limit the duration exposure in the US to 7 years.
Be selective within credits: focus on Europe and subordinated financials
Average valuation, positive technicals and deteriorating fundamentals. That is in a nutshell our take on the broader credit market. Differences between the subsectors are significant, so there is something to choose. We continue to prefer subordinated financials. Valuation is attractive as spreads are nearly three times as high as on senior financial bonds. From the perspective of a bond holder fundamentals are improving. Banks are clearly in a deleveraging mode as opposed to many (US) corporate issuers, where leverage is back at 2008 peak levels. Idiosyncratic risk needs to be managed though. Issue selection remains key. We prefer issuers from the United Kingdom, the Netherlands and Switzerland to institutions from Germany, Italy and Austria.
Kommer van Trigt, head of the Global Fixed Income Macro team at Robeco