Why central banks may be about to turn up the monetary policy dial

Image of United States Treasury

With virtually every other central bank in the world taking a softer line in 2019, it is no great surprise to see our very own Bank of England doing the same. Last week’s (20 June’s) Monetary Policy Committee vote of 9-0 to leave policy unchanged is perfectly in keeping with the concerns that the Bank continues to express about the economic implications of Brexit, but also wider concerns over global growth and inflation (and why we are not seeing enough of either).

Australia, New Zealand, Chile, India and Russia have all cut interest rates this year, the European Central Bank is considering further monetary stimulus and the US Federal Reserve is busily laying the groundwork for its first interest rate cut since December 2008.

The chances of the Bank of England looking to join Norway and the Czech Republic among those who have increased interest rates in 2019 look pretty slim, especially as any unexpected tightening of policy could give sterling a boost and perhaps hamper exports at what remains a delicate time for the UK economy.

Most recent moves in major central bank interest rates

Source: Refinitiv data

Advisers and clients must now address two issues. First, why are central banks readying themselves to play fast and loose with monetary policy once more? Second, what are the implications for portfolios?

Money makes the world go round

What appears to concern central banks more than anything else is their inability to stoke inflation (unlike the 1970s, when they made very heavy weather of slowing it down). This is reflected in US five-year, five-year forward inflation expectations. The market thinks that inflation in the US will be 1.8% in five years’ time, below the Fed’s 2% target, below the post-1948 average of 3.5% and barely above the 1.6% average of the past, post-crisis decade. Since inflation is in many ways about perception, this is a big thumbs down to 10 years of unorthodox monetary policy in the form of zero (or negative) interest rate policies (ZIRP and NIRP) and Quantitative Easing (QE).

Inflation expectations continue to slide lower in the US

Source: FRED – St. Louis Federal Reserve database

But central banks are also worrying about growth in a world where the US and China at daggers drawn over trade and tariffs is becoming the order of the day. Bond markets are responding to this by anticipating rate cuts and reflecting the failure to generate inflation. As the table shows, 10-year benchmark Government bond yields are lower than they were a decade ago, as we emerged from the Financial Crisis, and lower than when the Greek crisis was at its height in 2012. Again, this can be seen as a big raspberry to central banks and their growth and inflation policies.

Government bond yields are lower now than they were a decade ago

Source: Refinitiv data

Policy pickle

The issue that clients and advisers must ponder now is whether central banks can succeed by trying more of the same monetary medicine that has singularly failed to galvanise their patient economies (at least on a sustained basis) since 2009. The experiences of this century would perhaps suggest not, according to the bond market, at least, since yields on the 10-year Government paper have consistently trended lower since 2000 (if not the mid-1980s).

Inflation expectations continue to slide lower in the US

Source: FRED – St. Louis Federal Reserve database

Not that this seems likely to stop them from trying, and this is the hard bit for advisers and clients when it comes to portfolio construction and asset allocation.

  • Is the (renewed) slide in bond yield down to fears of deflation, or at least the abandonment of hope that central banks can stoke growth and inflation?

  • Or is it that bond market participants are just anticipating more NIRP, ZIRP and QE and doing their buying before the central banks do theirs? In either of these two cases, it is possible to argue that US 10-year Treasuries still look good value, even with a yield of around 2.0%. Markets are putting an 84% chance on the Fed’s target interest rate coming in below 2.0% by April 2020.

Markets are expecting rapid rate cuts from the Fed

Source: CME Fedwatch

  • But what happens if inflation does come back and central banks simply refuse to give in, cutting rates to zero (or beyond) and unleashing more QE? Government bonds will then be a horrible place to be, given where yields are right now.

The truth is no-one knows – not even central bankers. And there can be fewer better advertisements for keeping a diversified investment portfolio than that, especially as one unloved asset is pressing toward five-year highs: gold may be pricing in inflation or more money printing, but it is having a go at breaking above the $1,350 mark that has capped its advance several times in the past five years or so.

Gold is again looking for a break-out toward $1,400

Source: Refinitiv data

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.