Right or wrong, further central bank rate cuts still on the cards

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Just over a year ago the Chinese central bank’s seemingly innocuous 2% devaluation of the renminbi versus the dollar sent global equity markets and emerging market currencies into a tailspin, with the threat of a rarely-defined “hard landing” in Chinese economic growth grabbing the headlines. Global risk appetite once again fell off a cliff four months later as markets fretted over the possible end of ultra-loose US monetary policy after the Federal Reserve had the audacity of suggesting that more hikes could follow its first-hike-in-a-decade.

It is somewhat pointless to debate whether markets were “right” or “wrong” to react to these events as prices are simply the by-product of supply and demand and can remain “right” or “wrong” for long periods of time (put differently markets are neither right or wrong, they just are). But it is fair to say that between August 2015 and March 2016 markets were particularly sensitive to any “negative” news from the US and China, be it weaker than expected data points or a suspect policy announcement.

Fast forward twelve months and markets have swung to the other extreme, desensitized to “bad” news and happy to amplify any “good” news. Global equities are up, volatility has collapsed, bond prices have surged and EM currency rallies have extended. The lack of volatility in currency, equity and bond markets, which I highlighted in It’s oh so quiet…for now (14 June 2016), was only briefly interrupted by the Brexit vote, terrorist attacks in mainland Europe and an attempted coup in Turkey. There are some tangible explanations for this.

Fading brexit shock, Clinton in poll lead

The initial shock following the British electorate’s decision to leave the EU has faded. Sterling is still down about 12% (in trade weighted terms) since the referendum, but the boost to tourism, exports and domestic consumption from a more competitive currency is helping to dampen a downturn in domestic growth which remains difficult to quantify at this stage. It is not obvious to what extent the Bank of England’s recently announced measures will boost lending, investment and consumption given depressed business confidence and the uncertain outlook for UK trade, but they are playing their part by keeping sterling on the back foot.

Moreover, the confused and confusing legal and political debate about when Prime Minister May should/will trigger Article 50 has temporarily given way to the euphoria surrounding Great Britain’s impressive performance at the Rio Olympics – Team GB is currently second in the medals table behind the US. History suggests that this feel-good factor will eventually fade. After all gold medals don’t add much to companies’ bottom line or households’ purchasing power.

In the US, Republican presidential candidate Donald Trump has seen his support dip, with Democrat candidate Hilary Clinton extending her lead to about eight percentage points based on recent opinion polls. While it is fair to say that neither candidate has so far lit up the election race, financial markets are seemingly more comfortable with Clinton’s stance – however blurred – on global trade, international relations and finance.

But ultimately the underlying theme has been the willingness of developed and EM central banks to try and underpin economic growth by cutting policy rates further or in the case of the US further delaying its second rate hike.


Central banks’ real policy rates continue to grind lower but still above long-term average

A GDP-weighted average of major central banks’ policy rates is back down to a six-year low of about 1.86%. Policy rate cuts in the past eight months in Japan (10bp), Norway (25bp), the UK (25bp) – and the resumption of QE – Hungary (45bp), Australia (50bp), New Zealand (50bp), Russia (50bp) and most Asian economies have more than cancelled out rate hikes in Mexico (125bp), South Africa (75bp) and of course the United States’ 25bp hike on 16th December (see Figure 1).

At the same time, global headline CPI-inflation has risen about 0.5 percentage points from the 1% year-on-year low recorded in early 2015. The result has been an ongoing, albeit slow, fall in the average central bank real policy rate (ex-post) – the nominal policy rate minus CPI-inflation – to around 65bp in June 2016 after three and half years of sustained increases. The global real policy rate still remains about 20bp above its 10-year average.

Olivier Desbarres - Right or Wrong fig1

A GDP-weighted average of developed central bank (nominal) policy rates has fallen by another 5bp year-to-date, which is meaningful when the starting point was an already paltry 29bp (see Figure 2). The real policy rate (ex-post) remains firmly in negative territory but again is still broadly in line with the average of the past ten years (see Figure 3).

Olivier Desbarres - Right or Wrong fig2and3

The picture in emerging markets is somewhat more nuanced, with a broadly stable GDP-weighted central bank policy rate of 5.4% since end-2015 masking intra-country divergences (see Figure 4). While most Asian central banks as well and the Central Bank of Russia have cut their policy rates, their counterparts in Mexico, South Africa and Nigeria have been forced into hiking rates, broadly in line with my expectations (see More EM central banks to join EM rate cutting party, 30 September 2015, and Asymmetric risk to Emerging Market monetary policy, 6 august 2015).

But the GDP-weighted (nominal) EM policy rate, including China, is still within touching distance – 30bp to be precise – of the decade-low hit in late 2009 (see Figure 4). Of even greater significance is the 120bp fall in the average EM central bank real policy rate (ex-post) between early 2015 and June 2016 (the last available data point) after three and half years of sustained increases. But again the EM real policy rate in June 2016 was still about 30bp above its decade average.

Olivier Desbarres - Right or Wrong fig4

Central banks have woken up to deflationary threat, not obvious that governments have

While this loosening of monetary policy has so far been insufficient to stop, let alone reverse the gradual slowdown in global GDP growth to around 2.7% yoy in Q2, it has likely prevented the kind of growth meltdown recorded in late 2008 (see Figure 5). Moreover, based on the rebound in the global manufacturing PMI in July, global GDP growth started Q3 on a positive note and could be on course to hit around 2.8-2.9% yoy.

It is noteworthy that this gradual erosion rather than collapse in global growth is unique in the past 20 years (see Figure 6). Global growth in the past two decades has tended to either rise sharply as in 1999-2000, 2002-2004 and 2009-2010 or fall sharply as in 1998, 2001, 2008 and 2011-2013.

One interpretation is that central banks have gradually woken up to the reality that inflation is not going to rise sharply any time soon. Between mid-2011 and early 2015 central banks seemingly under-estimated the deflationary risk, fell behind the curve when it came to cutting rates and in the process allowed real policy rates to quickly climb back to levels last recorded in the 2007 heyday. This arguably contributed to the near halving of GDP growth from 5% yoy in Q1 2011.

Olivier Desbarres - Right or Wrong fig5and6

Looser interest rate policy has arguably fuelled economic growth in part by boosting asset prices, including of equities, bonds and property, which has in turn put a floor under business and consumer confidence. Rate cuts and QE of course are also designed to support lending, investing and borrowing but the evidence on this front has so far been mixed at best. It is certainly debatable whether looser monetary policy has done anything to drive global productivity growth. But central banks would rightly argue that this is principally the role of governments.

The IMF has in this context been pushing hard for governments to increase fiscal spending, particularly in infrastructure, but bar a few exceptions individual governments’ responses have been pretty tepid. Both Hilary Clinton and Donald Trump have promised to boost government spending on infrastructure but the ability and willingness of either presidential candidate to carry out these promises are likely to be tested once in office.

The former British government was committed to large infrastructure projects, including in transport and energy supply, but Theresa May’s recent appointment as prime minister has raised question marks about the future of some of these projects. Germany continues to apply the fiscal brakes and any spare Italian fiscal resources are likely to remain earmarked for the cleaning up of the banking sector. 

So what next?

The elephant in the room remains the Federal Reserve, which is due to meet three more times this year, on 21st September, 2nd November and 14th December. Markets have all but discounted a September tightening, pricing in only a 15% probability of a 25bp hike. While this may be a little skinny given decent labour market data, the Fed has given few clear indications that a rate hike is imminent. The Fed could understandably be reluctant to hike six days prior presidential elections scheduled for 8th November, even if it starts to more clearly lay the ground for a December rate hike. Moreover, the collapse in global risk appetite in the wake of the 16th December 2015 hike is likely to still be fresh in the mind of the Fed.

Ultimately the more important question is whether and how the Fed can hike for only the second time in a decade without again spooking markets and ultimately hurting sentiment and growth. This will be relevant to how other central banks react. If the Fed hikes, global sentiment reacts positively and the dollar appreciates, other major central banks may well be encouraged to hold back on any further rate cuts. But if markets fail to digest the next Fed hike and the dollar resumes its depreciation, other central banks are likely to again respond with rate cuts to support their own economies.

The bottom line, in my view, is that with global GDP growth hovering near multi-year lows, governments unable or unwilling to loosen the fiscal strings and markets still liable to be spooked by Fed action (or even talk), central banks are likely to welcome a further fall in real policy rates which are still slightly above their historical averages. Given that inflation is unlikely to rise markedly any time soon, this would imply that the risk remains biased towards further central bank rate cuts rather than hikes – whether or not already elevated bond prices and negative yields are “right” or “wrong”.

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

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