Deutsche Bank's long-held analogy of “plate-spinning” central bankers acting like the old popular circus act where the performers would spin plates on numerous poles and run between them in order to re-spin before they came crashing down to the ground, has held perfectly for several years. Over the years more plates have been added and central bankers have had to run faster and faster between them to stop gravity taking over.
But now Deutsche Bank is concerned:
Up to this year we’ve felt confident that they could continue this art for the foreseeable future and thus keep asset prices elevated as a result. We accepted that such policy wasn’t conducive for growth and prevented reform/creative destruction, but was positive in the short-term for most assets tied to monetary policy in some valuation form or another.
However 2016 has been a landmark year as we seem to have reached a point where the faster the plates are spun the more the unintended short-term consequences. The banking sector – especially in Europe and Japan – has been severely constrained by negative rates and flatter curves. If the sector was healthier they could withstand such an attack on their profitability but with inherent underlying weakness and with a need to build better regulatory defenses, monetary policy has started to be a sizeable negative. Given how important banks are to the wider economy then it’s no longer a win-win when central banks ease policy further. In fact in some cases the opposite outcome could materialise.
And assets are starting to misbehave…
Figure 9 shows the Stoxx 600 bank index against 10 year Bunds and then against bank loans to non-financial corporates (with the bank index lagged by 12m). 2016’s decline in Euro Stoxx bank equity (down –14% YTD, -36% at the YTD lows on 6 July 2016) does not bode well for 2017 bank lending on this measure. However the reversal seen since the lows is perhaps offering some hope and reflects a view that policy makers are appreciating that a change is needed. Since September 2016 we’ve seen the BoJ target the yield curve more than targeting a specific volume of QE, and more recently the US election result brings hopes of a shift in policy emphasis. The ECB is going to find it the hardest to shift policy but even here it’s becoming more evident that there is great resistance to cutting rates any further or expanding QE.
The risk is that some damage to the European economy has already been done by the woes of the banking sector in 2016. The rightmost chart of Figure 9 perhaps backs this up by looking at the ECB’s Euro area bank lending survey for Q3 (published on 18 October 2016) which showed the first expectations of tighter standards for lending to corporates in nearly 3 years. At this stage it is a small subtle shift and to put things in perspective, the previous quarter saw 95% of reporting banks expecting to leave standards for lending to enterprises unchanged over the next 3 months, 3% to ease somewhat and only 2% to tighten somewhat. In Q3 2016, the corresponding numbers were 90%, 3% and 7%.
Is this another small sign that monetary policy is becoming counterproductive for the economy? Although standards are still expected to be net eased to households for both consumer credit and house purchases over the next quarter, the rate of easing was less than in Q2 and getting closer to zero.
The unintended consequences of central bank actions are starting to become clearer…
It is not clear that the ECB has any inclination to change direction regardless of the US election result but it feels increasingly unlikely that they can ease further without causing collateral damage. The path of monetary policy is becoming more and more complicated. So it seems highly unlikely that the ECB will increase QE or cut rates further in 2017. Although we think they’ll struggle to taper in numerical terms in 2017, we think that they will announce a ‘soft taper’ at their December 2016 meeting where they will remove the deposit rate floor and thus allow them to open up more shorter dated securities for purchase which would reduce the average duration of their portfolio.
Alongside recent events in the US, this may ensure that both yields and the yield curve have already hit their low/flattest levels for this cycle in Europe and thus provide some relief for banks and the economy. It could even be that we’ll never again see the lows in yield we saw in late September 2016. These were lows never previously seen through hundreds of years of history. Even with the respite, given the lag in the correlation seen in the middle chart of Figure 9, we have to be wary that some damage may have already been done to lending in 2017.
A proper taper will be difficult when the ECB have yet to meet their economic objectives but at the same time the removal of the depo floor may only give the ECB an extra 6 months of being able to buy German Bunds out to January 2018 before they run into constraints. So unless we see radical policy change in December 2016, this theme will continue to be a focus over the next 12 months with tapering speculation never far off the agenda especially with the potential change in policy mix in the US. It sounds like a recipe for increased volatility and higher risk premiums.
With regards to the BoJ, they have at first glance moved towards tapering as they have shifted away from a specific volume of monthly purchases and are instead targeting the yield curve and vowing to keep 10 year JGB yields close to zero. Our Japanese strategists estimate that this could reduce the annual purchases from 80 trillion to around 60 trillion Yen and Kuroda has also openly suggested that a reduction of purchases is likely. However following the outcome of the US elections, the BoJ’s policy could be tested if yields continue to rise on a global basis. Will they (i) defend the zero percent 10 year JGB yield and buy more bonds than they and the market expected when the new policy was announced or (ii) will they amend policy? Again the uncertainty is high and will likely have big implications for global bond yields and asset prices generally.
What’s more certain is that central banks will still be significant buyers of assets next year, just not as much as in 2016. This may be slightly more positive for bank related risk but might be slightly less positive for other assets previously propelled by asset purchases. For example our US rate strategists believe the new BoJ policy could be worth 20-25bps in terms of higher US yields and the anticipated changes from the ECB might add a further 10bps all other things being equal. President-Elect Trump’s spending plans add another 40bps according to their model. So since September the fair value level of yields have started to rise even though QE still remains at high levels around the world.
Figure 10 shows the YoY USD change in global central bank assets across nine major economies. 2016 will likely be seen as a local peak for aggressive monetary policy with the risks to this graph perhaps on the downside as the ECB is more likely to taper than add to QE.
2017 won’t represent a radical shift in central bank policy around the globe but the momentum and sentiment shift away from peak QE / negative rates may be greater than that simply implied by the numerical shift, especially with the new US political administration.
So while hopeful that we’re starting to break free from the previous policy regime, Deutsche Bank reminds readers that…
…the global financial system remains broken and extremely fragile. Secular stagnation trends are everywhere. The world has too big a debt burden for the current growth environment.
We would feel far more comfortable if the world went through a huge creative destruction period where zombie, inefficient debt was allowed to default – thus ‘right-sizing’ the ratio between debt and GDP. However we’ve long accepted that this is highly unlikely to happen outside of perhaps a future break-up of the Euro.
The debt is too systemic for policymakers to be able to let it default without a big negative feedback loop on growth that could easily lead to a depression. The problem with current policy – which at a global level has become more and more extreme on the monetary side – is that it simply props up the failed system without offering much in terms of nominal growth stimulus.
So you actually prolong the ‘zombie economy’ with the added problem of the weaker banking systems (e.g. European) starting to buckle under the weight of negative yields and QE in extremis. So monetary only policy was starting to risk the health of the system it was trying to prop up. Not a positive development for growth.