Over the last ten years, central banks around the world have cut interest rates and boosted their quantitative easing (QE) programmes to historic levels. But we are now seeing some signs of a change in momentum as they start down the long road to normalising monetary policy.
The US Federal Reserve (Fed) is leading the way. Three (albeit modest) interest rate rises were made in 2017, with one so far in 2018 and two or three more expected later this year. In addition, Janet Yellen (Jerome Powell’s predecessor in the Fed’s hot-seat) oversaw the start of QE tapering last autumn. Tapering – the reduction in the scale of the central bank’s bond purchases – has now started to accelerate. So, is this a sign of things to come in the UK?
Mark Carney’s interest rate conundrum
Having all but promised a May rate hike, the Monetary Policy Committee (MPC) held fire. Members voted 7-2 against, citing disruption to economic growth from the ‘Beast from the East’. Bank of England (BoE) Chairman Mark Carney has been dubbed the ‘unreliable boyfriend’ by commentators due to past tendencies to not deliver on promises.
However, we believe the decision this time seems sensible.
In the US, the Fed has been able to make changes due to the strong economy. The UK isn’t on such stable economic footing, making life more difficult for policy makers. Growth has fallen from 0.4% in Q4 to 0.1% in Q1; the poorest reading since Q4 2012.
Although Mr Carney has stated his rate rise intentions in the past, he has also reiterated his commitment to paying attention to data and being open to altering his opinion accordingly. Some may see this as flip-flopping, but we think it’s difficult to make a convincing case for a rate hike given the backdrop.
So it looks like the can is being kicked down the road at the moment. Even if we do see a 0.25% increase later this year, we don’t see significant rate changes occurring any time soon.
Winding down QE
With QE never having been implemented on this scale before, there’s no blue print to follow to bring balance sheets back down. Janet Yellen claimed that it would be ‘like watching paint dry’ in an attempt to convince markets that quantitative tightening (QT) – the process of reversing previous QE measures – is a non-issue. Pleasingly for the Fed, markets have so far taken the initial tapering steps in their stride.
This has been helped by the Fed’s clear communication; something central bankers have been especially concerned about since 2013’s ‘Taper Tantrum’ sent US treasury yields surging.
For the BoE, we don’t see tapering on the immediate horizon. At May’s MPC meeting, members voted unanimously to maintain bond purchases at current levels and they have not flagged plans for changes any time soon.
Given that unexpected announcements tend to cause significant market disruption, we believe it’s highly unlikely they would risk rocking the boat. Instead we think that when the time comes, their plans will be clearly signposted well in advance.
Risk for markets?
One thing’s certain – markets don’t like surprises. At the moment we don’t anticipate the BoE blindsiding investors with any shock announcements. It would likely take a very significant change in economic data to alter members’ cautious stance, especially given the MPC’s dovish tendencies.
The Fed’s tapering programme does carry greater potential to upset investors further down the line though, especially given the US’ global influence. Although markets have so far taken well to tapering, there’s the possibility that investors have become slightly complacent.
By keeping bond yields low, QE has changed the investing environment hugely, pushing yield-hungry investors out on the risk spectrum. Once the pace of withdrawals ramps up and liquidity tightens further, it’s certainly possible markets could become volatile as investors adjust to the new environment.
Having said this, we think there are other risks which have greater potential to upset investors.
Managing the threat
We don’t see tapering as an immediate threat but are instead more focused on interest rate risk. This is something we are conscious of, mainly for the US. The strength of the US economy has led to fears of inflationary pressure forcing the Fed into increasing interest rates quicker than targeted. This could definitely rock the boat and we had a taste of it in February thanks to unexpectedly strong US jobs data. Our company view is therefore to be slightly underweight exposure to interest rate risk in our bond holdings.
The key word is still diversification to spread the risk of unexpected shocks to asset classes. Although we are wary of interest rate risk, we think it’s still beneficial to hold some assets with exposure to this risk. If we see an unexpected increase in equity market volatility, holding a combination of government and corporate bonds should provide protection to portfolios.
Sheldon MacDonald, Deputy Chief Investment Officer
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