The past is a foreign country for central banks and investors. Not so long ago, an overheating economy would be cooled by higher interest rates, while a swift round of rate cuts would be deployed to counter weakness.
Now policymaking is an altogether far more frustrating experience. The machinations of central bankers appear to exert much less of an influence on growth and inflation, but at the same time they have become a key driver of financial markets and rises in asset prices.
In the case of the European Central Bank, monetary policy is near a limit, while relying on a weaker euro to stimulate exports risks sparking a currency war with the US. Disinflationary pressure amid a global manufacturing and trading slump, leaves the ECB ready to ease policy in September. Yet, the eurozone already has a negative overnight deposit rate of minus 0.4 per cent, a level that the 10-year German Bund yield briefly ventured beyond this week.
The prospect of renewed easing by the ECB only stands to intensify an already distorted bond market and encourage investors to buy riskier assets. At some point, that could become a trigger for a nasty bout of financial turmoil.
This column has highlighted how low global bond yields help sustain high valuations for equities and credit. Signs of earnings growth flatlining, or companies cutting their guidance for the coming quarters in the US and Europe, appear not to matter, as investors have a powerful tailwind from central banks. The “lower for longer” trade means corrections in equity and credit markets are limited. But not all boats are floating higher, as equity investors favour quality and growth companies along with those that pay high dividends. It can be appealing to buy deeply unloved stocks as they are cheap. But the value trade really kicks into life only when economic conditions brighten.
Alan Ruskin, a senior currencies analyst at Deutsche Bank, says that on the evidence of recent client meetings, ’two seemingly contradictory themes are dominating portfolio thinking.”
The prospect of renewed asset purchases from central banks encourages a hunt for yield, that has propelled a number of emerging market currencies higher. Borrowing for next to nothing in one currency and ploughing the proceeds into higher yielding assets is great when central banks are keeping a lid on volatility. But the problem with so-called “carry trades” is that they can break down, usually with little warning.
The other side of the hunt for yield is an extreme risk averse trade, buying long dated government and high quality corporate bonds that will benefit should the lower-for-longer trade in rates ultimately end up near or below zero. Tagging along for the ride are gold and haven currencies such as the yen and Swiss franc.
Mr Ruskin says both trades can prosper over the next three months as central banks led by the Fed retain policy credibility while lifting “risk appetite’’.
Longer term, the danger is that monetary policy fails to combat a slowing global economy and that highly indebted companies struggle with falling profitability. Eventually this triggers losses and an inability to refinance their debts.
Plenty therefore rests on central banks stemming such an outcome when there are strong doubts over the effectiveness of expanding bond purchases and, in the case of Europe, cutting interest rates further into negative territory.
Officials, in fairness, recognise the limitations of monetary policy. This week Mario Draghi of the ECB peppered his press conference with numerous calls for deploying fiscal ammunition. Andy Haldane of the Bank of England added: “Super-charging the supply side of the economy is what is now needed.’’
Unfortunately, fiscal measures are likely to be used only after economic activity has suffered a hard landing. Given the manufacturing pressure on Germany at the moment, one has to ask when Europe’s biggest economy will start spending and prevent even a flirtation with recession.
While a global financial system dominated by high levels of debt limits the scope for rising interest rates, it also keeps the cost of borrowing low, so the window is open for government-backed spending.
This is where some innovative thinking from central banks can play a role. Rather than simply repeat past bouts of generic bond buying, in the case of the ECB, they could help fund eurozone infrastructure and green projects and even clean up the banking system by purchasing non-performing loans. One idea from Sebastien Galy at Nordea Asset Management involves the ECB partnering with the European Investment Bank to create vehicles investing in start-ups that ‘’boost productivity in the long run and increase the speed with which mature sectors adapt to the new economy.”
While Mr Draghi appears set to end his term with another blast from the easing past, his successor, Christine Lagarde faces the enormous challenge of convincing Europe to try some much-needed fresh approaches.