L&GIM’s Bennett provides fixed income focus

Central banks are driving bond and equity markets often in ways
that seem at odds with economic fundamentals, according to Ben Bennett,
Credit strategist at L&G Investment Management.

I am particularly frustrated right now by the ‘will they, won’t they’ speculation frenzy surrounding the US Federal Reserve decision to taper their quantitative easing (QE) programme. But instead of joining the herd, let’s try and focus on what is really going on with central banks and what it means for markets.

Starting with the US Fed, they have been aggressively printing money in
one form or another for most of the time since the start of the financial crisis. Despite the vast quantity of money injected into the system, economic growth remains rather sluggish and business leaders are somewhat reluctant to start a new investment cycle. So what would happen if the Fed decreases its current money printing programme?

The hope is that US consumers are in a stronger position today as they are not facing a repeat of last year’s tax hikes. However, it’s hard to imagine the US economy being immune to slowing stimulus given the housing market’s sensitivity to liquidity conditions. Indeed, while improving economic growth is usually associated with rising yields, the chart overleaf shows that previous QE withdrawals have actually led to lower rates, as the economy has slumped in the absence of its methadone.

The most likely scenario for 2014 is therefore that QE is reduced a little, but not very much, given the economy’s addiction. Such a cautious stance is a reasonably good backdrop for bonds in general, and credit in particular, but it’s unlikely to be a smooth ride. The European Central Bank (ECB) has had its hands tied by the structural weakness in the euro and the differing interests of its members. With European banks still shrinking their balance sheets, the ECB needs to replace the money in the system or else face deflationary pressure. Ironically, with European political crises starting to fade, there is now less enthusiasm to implement extraordinary monetary policies such as the SMP programme (sterilised buying of peripheral government bonds) let alone unsterilised QE.

The last conventional bullet remaining in their fight against deflation was
fired in the November meeting with a 25bp rate cut. Any future rate cut may have to take the deposit rate into negative territory, and while this should not be a problem in theory, nominal declines in deposits can have serious consequences: just ask the citizens of Cyprus, who are still living with capital controls. The hope is for an economic revival that restarts traditional bank lending, but with the latest in a line of comically unsuccessful stress tests being steadily postponed to the end of 2014, such hope may prove unfulfilled for some time to come.

Of course lower inflation, and even deflation, is not a bad backdrop for bonds, but the risk remains that weak nominal growth will trigger another euro crisis flare-up. The Bank of England appears to have done a reasonable job in terms of printing money earlier in the crisis to offset
the rapid retrenchment of the banking sector and then supporting the government’s effort to inflate the housing market.

The only nagging doubt is that we’re getting the wrong type of growth, driven by asset price increases and not by real economic activity. From a bondholder’s perspective, the concern would be that the BoE has to raise interest rates to offset rising inflation before the economy has time to rebalance.

At least the UK has a large group of pension fund investors who are keen to lock into higher interest rates at the longer end of the curve. Those mortgage holders with sensitivity to BoE base rates are not quite as eager. While each region therefore faces different circumstances, there is a common hope that economic activity will make central bankers’ jobs a lot easier. They believe that their various forms of medicine will eventually revive the patient in 2014, but my suspicion is that their actions to date have simply been suppressing the symptoms.

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