Monetary policy updates
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The writer is chief market strategist for Emea at JPMorgan Asset Management
It’s nearly that time of year when the biggest names in the US central banking community gather for the Federal Reserve’s annual conference in Jackson Hole. And while this year’s conference will now be virtual, it should nevertheless carry more weight and significance for the global investor community than usual. The need to compare notes, to spot any potential shift in thinking, is more pressing than ever.
Central banks need to be formulating and communicating a clear and coherent plan for how they intend to exit the extraordinary policies put in place during the crisis. Perhaps because Bank of England governor Andrew Bailey did not plan to attend in person, the BoE chose to communicate its exit strategy earlier in the month. Global investors — of both stocks and bonds — should take a careful look at this blueprint. If mirrored by other central banks, it will have significant implications for global markets.
The plan is as follows. The BoE’s main interest rate that is currently 0.1 per cent — known as Bank Rate — will rise first. But when it reaches 0.5 per cent, the BoE will switch its focus and start to reduce its balance sheet by not reinvesting the funds it receives as its holdings of government and corporate bonds mature. If that proceeds smoothly, the central bank might start raising rates above 0.5 per cent. When this main rate reaches 1 per cent it will consider actively selling some of its bonds, leading to a quicker reduction in the balance sheet.
Note that this exit strategy prioritises reducing the BoE’s balance sheet, a very different plan to the one the central bank put in place after the financial crisis. Back then, it did not emphasise balance sheet reduction, instead wanting its Bank Rate to reach 1.5 per cent before it considered unwinding its asset purchases.
This shift looks like a deeper strategic rethink. Reading between the carefully crafted lines of the policy statement, the BoE seems less concerned about reducing the balance sheet, so long as it is conducted in periods of market calm.
Bailey may well believe that central banks should “go big and go fast” with asset purchases in crises. But, to do so, they would need the capacity to buy assets and, therefore, must reduce their stock of holdings during periods of recovery.
The BoE is not alone in reconsidering the relative merits of raising policy rates versus balance sheet reduction. Recent comments from the Reserve Bank of New Zealand suggest a similar view there. These smaller institutions by themselves are unlikely to have a big impact on global markets. Much depends on what the Fed thinks.
The Fed has some catching up to do. It first needs to stop expanding its balance sheet before considering shifting into reverse gear. It still buys $80bn of Treasuries and $40bn of mortgage-backed securities a month — the same rate of purchases at the height of the pandemic. How the Fed might slow, or taper, its purchases rather than sell them matters to markets.
But the point still stands. How does the Fed feel about its $8tn balance sheet? Will it set out an overarching ambition to slim it down in the years ahead?
Any indication that central banks have shifted the relative importance of short-term interest rates versus balance sheet policy should steepen government bond curves, as longer maturity bonds sell off. This change may also reduce demand for riskier corporate credit if investors no longer need to search so hard for yield.
But this matters not just to bondholders. Longer-term interest rates have been the tail wagging the equity market dog, so to speak, over the course of this year.
Consider what we saw in the first quarter of this year. When the 10-year Treasury yield rose by more than 80 basis points, reaching 1.74 per cent on March 31, that coincided with a significant style rotation in equity markets. The MSCI World Value index rose nearly 9 per cent during that period, while MSCI World Growth hardly moved.
This, in turn, led to cheaper equity markets, such as in Europe, outperforming the US. However, when the 10-year Treasury yield later plunged to 1.17 per cent by early August, growth stocks outperformed once again.
Expectations of future central bank actions can always move markets but never more so than today. Investors need to watch for any potential shift in thinking. If balance sheet reduction becomes a priority, then the implications for global markets are profound.
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