Over the past year, global economic growth has improved to the point we’re now observing the most synchronised growth since 2009. Activity in the US has been underpinned by rising real middle-class incomes and solid growth in business investment. Europe, too, has experienced rapidly falling unemployment, buoyant activity with its trade partners and a backlog of corporate activity being deployed with the reduced political risk. Asian growth has been underpinned by Chinese fiscal expansion and a rapidly expanding middle class.
All three of the major developed world central banks – the US Federal Reserve (Fed), the European Central Bank (ECB) and the Bank of Japan (BOJ) – have been buying substantial volumes of long-dated government bonds to help spur business investment. But these asset purchase programs are now past their use by date, with central banks now recognising the shortcomings of these programs. President of the Federal Reserve Bank of Minneapolis, Neel Kashari recently said, “I think the big big balance sheet isn’t doing a lot to boost the economy.” More acutely, the ECB asset purchases are becoming counterproductive; elevating consumer savings, reducing income growth, lifting asset prices, exacerbating income inequality, harming bank profitability—resulting in less lending to businesses and flattening of the yield curve.
With the exception of the US, we do not expect interest rates to increase, but we do expect longer-dated bond yields will rise as the quantitative easing (QE) policies of these banks are gradually unwound. The big question is whether central banks can unwind their QE programs if inflation stagnates or falls?
Ultimately, cyclical inflation needs to outweigh the structural deflation headwinds of globalisation.
The central banks had been confident that the economic recoveries underway in the US and Europe were sufficient to lift core inflation to their target of 2% and allow them to unwind their unconventional monetary policy activities. This confidence was largely driven by a 22% lift in oil prices during the 4th quarter of 2016, annual headline US inflation rose to 2.74% in February this year. European inflation hit 2% at the same time. Wages and inflation expectations are influenced by or indexed to headline inflation rates.
However, between February and June this year, oil prices fell approximately 20%, and with it headline inflation. Annual headline inflation in the US as a result fell to 1.63% (June 2017). Combined with a 12% rise in the Euro, European headline inflation fell to 1.3%. This has somewhat unnerved central bankers. John Williams, the President of the Federal Reserve Bank of San Francisco, said in early July, “Forecasts for one or more rate increases this year seem reasonable”. By the 2 Aug, however, his outlook had modified to, “We still have a way to go in terms of inflation."
Mario Draghi, the President of the ECB, flagged in a June speech the possibility of an announcement of a tapering of asset purchases. But in July, he backtracked, saying “Inflation is now where we want it to be and where it should be.”
Given Janet Yellen, the President of the US Fed, has previously articulated that the shrinkage of the balance sheet is not a monetary policy tool, we believe the Fed will phase out the reinvestment purchases of US treasuries this year. Further interest rate rises, though, are threatened by the fall in inflation.
In our view, the more important influence on bond rates is a European central bank pivot. It is unlikely long-dated Australian and US bond rates can lift appreciably with key European rates around their current low yields. We also believe it makes sense for the ECB to unwind QE and it will likely need a supporting inflation narrative to allow this. Ultimately, a stronger Euro will have a disinflationary impact and likely delay the commencement asset purchase tapering.
Of course this makes oil price movements all the more important. While there is a lagged impact, oil prices have recovered 17% since early June. Assuming this doesn’t fade, central bank confidence will lift and, with it, so will their ability to unwind their QE programs. This is what could drive cyclical inflation to outweigh structural influences and give rise to something of a virtuous cycle between wages and inflation, via expectations. The challenge of course will then be for the ECB to avoid a ‘taper tantrum’ in markets.