InvestmentsSep 27 2016

The Limits to Monetary Policy

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The Bank of Japan last month pushed back the frontiers for global monetary policy, demonstrating once again that its policymakers have little fear of experimental innovation.

The recent BOJ announcement not only aspires to an intentional, temporary overshooting of the inflation target, but also sets out an explicit target for long-term rates, expressed via 10-year Japanese government bond yields.

This marks a potentially momentous milestone for investors, as central banks are again being forced to delve into ever-more esoteric and untested parts of their toolkit.

Large swathes of the world continue to face shortfalls in nominal demand. Inflation expectations are well below target, and credit flows to the real economy in many countries are anaemic.

Yet the outlook is not unremittingly bleak, in my opinion. In particular, we would point to the US economic recovery as a cause for moderate optimism.

We view the US labour market as solid, slack in the broader economy as limited, and consequently we see inflationary pressures -- with the core US consumer price index above 2 per cent for the ninth straight month in July -- starting to build. 

As a result, we believe monetary policies around the world are now likely to head in divergent directions. After a 35-year bond bull market run, the US has reached an inflection point, even as there is much uncertainty around the pace of policy normalisation.

Elsewhere, particularly in Europe and Japan, accommodative monetary policy continues in an effort to reflate the economy.

The trouble we see with a continuation of extraordinary monetary policy in Europe and Japan is that there is a slowly diminishing set of viable policy options left available to central bankers, with market perceptions of these policies’ efficacy also diminishing. A shift towards a more supportive fiscal policy in certain economies strikes us as the logical next step. 

From an investment perspective, we think the impact of widening interest rate differentials creates a case for dynamism in the face of changes in relative value. Not only do absolute interest rate levels (positive or negative) affect investment performance, but so do market expectations.

Although the market’s estimate since the UK’s Brexit vote of a low probability of further rate hikes from the Federal Reserve (Fed) during 2016 seems reasonable, we believe adjustments towards higher yields would more likely occur at the longer end of the curve.

Recently announced measures to blunt the impact of further rate cuts upon the banking sector are likely to alleviate some pressure on financials

Outside the US, we think the European Central Bank and Bank of England could still cut rates further if needed. Those moves would be important not only for rate markets but also for foreign exchange. 

We also think investors need to accept the notion that a more volatile rate environment could be persistent. Not only have many central banks slashed rates to record lows, but they have kept rates stable for record periods of time.

This point holds true both for rate increasers (the US until December 2015) and rate cutters (the BoJ until the first move lower in January, and the Bank of England until early August). As policy rates shake off their slumber and become active policy tools (in both directions), we can naturally expect a range of opinions about policy trajectories.

Policymakers themselves are likely to be sensitive to market and macro conditions, as there is no predetermined course. Major surprises could cause policymakers to change course rapidly.

Consequently, for investors, we see a commensurate need for dynamic investing, meaning having the ability not only to resize positioning according to the evolution of the economic outlook, but also to express both long and short duration views depending on where the market is relative to fundamentals.

In our view, any dissonance between fundamentals and valuations creates potential investment opportunities. In this respect, we believe that flexible, relative value implementation can be of great help in turning market volatility into an additional potential source of opportunity.

This means upgrading the role “flexibility” plays in portfolios from a desirable characteristic to an integral one.

Taking a longer-term perspective, we think the Euro area and Japan are likely to remain in low-rate (negative) environments for a prolonged period, with both economies still a number of years from equilibrium.

As a result, we think the next move from the respective central banks will be to deploy some more of those easing options outlined above, most likely “standard” quantitative and credit easing measures before anything more radical.

Meanwhile, pressure for fiscal action in the developed world seems likely to continue. Recently announced measures to blunt the impact of further rate cuts upon the banking sector are likely to alleviate some pressure on financials, altering the dynamic for both financial equity and credit.

As Europe and Japan ease, we think the Fed will pursue its normalisation strategy at a pace which is considerably slower than historical norms.

But even this slower approach has the potential to cause material adjustments to the shape of the yield curve and to market participant’s forward looking growth and inflation expectations.

I see these forces, together with actual policy decisions, playing an increasingly important role influencing the shape of the curve.

James Ashley is head of international market strategy for strategic advisory solutions at Goldman Sachs Asset Management