- Financial markets have calmed since the spring. But, with macro & earnings recoveries below par & vulnerable, central banks daren’t remove the tide of liquidity covering the sharp rocks beneath. After seven years, though, their monetary tool-boxes look bare.
- The Fed having raised rates once is the test-case for whether central banks can ever ‘normalise’ monetary policy. We expect it to try, hiking twice more, but peaking out early at just 1%. This suggests another two years of negative real rates, in the US & UK.
- Deflation-prone Japan & the euro-zone can’t be sure of that. The euro-zone is halfway down the Japan route. It too may be accelerating QE & running negative rates, but has yet to loosen the fiscal reins. Its sharp defi cit reduction, though, suggests it can.
- ‘Helicopter money’ is considered a next step. The absence of a euro-zone-wide fiscal agency precludes a unified giveaway akin to the US tax-rebate cheques. But, it could still be done nationally, with reform back-end loaded to allow growth & protect ratings.
- A complication is the UK referendum. Brexit can still be avoided, but exit-fears could extend beyond June & the UK. With the EU’s haven status questioned (& as the ECB runs QE), this could benefit the USD - putting an extra, early brake on the Fed’s normalisation.
- And with general elections due next year in France, Germany, & potentially Italy & The Netherlands, they may have little sympathy for a quick, ‘no-strings’ UK deal. The (new) UK Chancellor may yet have to forego returning to budget surplus by 2019/20.
- China’s dilemma is to cut borrowing costs while property transactions outpace new starts by about two-to-one. There too, the result is probably fiscal expansion. The big macro risk is a policy face-off between US rate hikes & renminbi devaluations.
- But, with growth under threat, funding costs low/negative, & infrastructure needs high, it surely makes sense for stubbornly slow-growth Europe & Japan to relax fiscally - using the aggressive QE they’re doing anyway to cap any rise in bond yields?...
Market Risk Insights Q2 16