In the wake of the US Federal Reserve lifting interest rates for the first time in nearly a decade in December, other major central banks have wasted little time announcing additional monetary policy stimulus in an attempt to bolster their own flagging economic fortunes.
Since the beginning of the year the European Central Bank (ECB) has laid the foundation to implement further policy stimulus, most likely at its March policy meeting, while on January 29 the Bank of Japan (BOJ) stunned investors, adopting a negative interest rate policy that practically nobody expected.
According to Deutsche Bank’s strategy team, consisting of Binky Chandha, Parag Thatte and Rajat Dua, while the measures outlined by the ECB and BOJ were designed to push investors out of cash and fixed income products into riskier assets such as stocks, arguably their impact has been quite the opposite.
Inflows into fixed income assets have accelerated, pushing great swathes of Japanese and European government bonds into negatively yielding territory, while global stock markets have cratered.
Not exactly the response the ECB and BOJ were looking for, with signs of increased “animal spirits” from investors noticeably absent.
“Though a large over allocation to fixed income at the expense of equities already exists as a result of past Fed QEs and a lack of normalisation of rates, further easing by the ECB and BOJ that lower bond yields globally will only exacerbate the over allocation to bonds,” wrote Chandha, Thatte and Dua in a research note.
The charts below from Deutsche reveal how ultra-aggressive monetary policy easing from the Fed, ECB and BOJ has seen investors pile into bond markets to the detriment of stocks.
Not only do Deutsche believe that recent policy easing, or indications that it has been coming, caused investors to pile into the perceived safety of the sovereign bond market, they also believe that it is creating even greater headwinds for other asset classes, along with the US and Chinese economies.
The strategy team explains:
Asynchronous easing by the ECB and BOJ while the Fed is on hold risks speeding up the dollar’s up cycle, pushing oil prices lower and exacerbating credit concerns in the Energy, Metals and Mining sectors. It is notable that the ECB’s adoption of negative rates in mid-2014 which prompted the large move in the dollar and collapse in oil prices, marked the beginning of the now huge outflows from High Yield. These flows out of High Yield rotated into High Grade, ironically moving up not down the risk spectrum.
Asynchronous easing by the ECB and BOJ that is reflected in the US dollar commensurately raises the trade-weighted RMB and increase the risk of a disorderly devaluation by China.
While the inflows into global bond markets risks reversing at some point in the future – which may eventually support global stock markets – with the BOJ and ECB implementing even greater policy stimulus and the Fed seemingly on hold in the months ahead, the current trend in market flows appears likely to continue in at least the short to medium term.
In the interim, the question many are now grappling with is whether there’ll be enough time for market flows to reverse without causing enough damage to the world’s largest economies, the US and China.
Commodity prices have been pressured, increasing the risk of corporate defaults, while firms in China and the US have been buffeted by a significant appreciation in their currencies, hurting corporate profitability.
Further easing could further exacerbate those factors, leading to a greater risk of a global economic slowdown.
Should that happen it would be deemed to be an unintended consequence of delivering additional policy stimulus, essentially mitigating the effects of trying to stimulate individual nations by slowing the global economy as a consequence.
Deutsche mentions the increased risks of mounting defaults over high yield debt tied to the energy and mining sectors, along with the potential for a disorderly devaluation in the Chinese yuan. Twice over the past six months we have seen the potential for this to rattle markets.
The truth is that there are any number of risks that appear to be building, none less than that of a recession occurring in the US or China, or both.
The cycle of passing on currency strength from one nation to the next has now been ongoing since the depths of the global financial crisis, some seven years ago. In that time global growth has been tepid, even with an unprecedented infrastructure spend in China and mammoth increase in the US Feds balance sheet thanks to its series of quantitative easing programs.
Essentially, what the world has seen ever aggressive monetary policy being delivered for increasingly small returns.
It’s little wonder why many believe that additional policy stimulus is losing its potency, and why so many investors are nervous.