NN IP: Financial markets and the unbalanced policy mix

As of this writing, financial markets have calmed down again, but the story of the past few weeks is of course the sell-off in risky asset space in general and credit space in particular that gripped the market for a few trading days. From a macro point of view, this sell-off should be put in perspective. For now it is a hiccup in what is otherwise an easing trend in financial conditions. In particular, equities and credit spreads have rallied since the start of the year, while safe Treasury yields are stable to somewhat lower and the dollar has depreciated on balance. As a result, financial markets pretty much reveal a footprint of monetary easing even though the Fed raised the policy rate by a cumulative 50 bps this year, and is set to hike by a further 25 bp in December. One of the most often-heard partial explanations for the sell-off in credit space was the repricing of Fed expectations. In this respect, one has to bear in mind that market pricing pertains to the mean expectation across all market participants and says little about the balance of risks seen by these participants individually and collectively. It could well be that the scenario of continued low inflation rates has by now become very much consensus in the market. If this is true, it means that new data that are consistent with the lowflation scenario should not move markets much. By contrast, data that give a hint of a pick-up in inflation momentum could have a pretty big effect on Fed pricing and hence risky assets. Perhaps investors are becoming more aware of these asymmetric risks in the light of pretty tight credit valuation measures. 

What’s more, this heightened sensitivity to the risk of positive inflation surprises may interact with the aforementioned monetary policy-driven easing of financial conditions. Because the Fed has increased the real policy rate somewhat, this points to an increase in the unobservable neutral real policy rate r-star. This animal is the real policy rate which ensures full employment and stable, on-target inflation. As such it is very much driven by the desire to save, the appetite to invest and risk appetite in financial markets. The rise in r-star could thus have been a consequence of better global growth momentum that is driven by less savings and more investment. Alternatively, risk appetite in markets could have been lifted by positive animal spirits, which are also reflected in business and consumer confidence in the real economy. If that is the case, then the concomitant reduction in risk premiums will have pushed up r-star and improved growth momentum. There is actually a good chance that both mechanisms were operating simultaneously and have reinforced each other. Essentially, what you get then is an increase in r-star, triggered by a stronger positive feedback loop between financial conditions and growth momentum. 

The important point to note here is that this easing of financial conditions takes place in an environment where the policy mix in DM space has been unbalanced for a long time. As a result, central banks have been driven much further into unconventional territory than was strictly necessary. The further you get into unconventional territory and the longer you stay there, the bigger the risk of non-negligible undesired side effects. The latter could pertain to a decrease in bank profitability, which could have a negative effect on credit supply. It could also come from decreased returns for pension funds, which feeds back into a negative effect on consumer spending, etc. Even in Euroland we believe that these negative effects are still pretty small or at least not dominant relative to the positive effects of unconventional easing. After all, credit supply is still easing and consumer spending is pretty robust. As a general rule, monetary policy will always have unintended distributional consequences via changes in asset prices that are correcting a deviation of inflation from the target. These should not be a reason not to take the policy action. 

The only relevant benchmark for judging success here is whether or not easier monetary policy is a stabilizing force for nominal GDP. Still we should keep an open mind about the unintended consequences of unconventional easing. One of these consequences could be a bout of irrational exuberance in some market segments. More precisely, unconventional monetary policy easing of course aims to ease financial conditions, which amounts to compressing risk premiums. However, in a world where safe Treasury yields are already low for a long time, this could potentially lead to a search for yield in some segments, which takes on a life of its own and drives valuations of some risky assets to pretty tight levels. At this point, these assets may become susceptible to corrections on the back of a bit of negative news. In this respect, credits have the handicap that the asymmetry in the distribution of future absolute returns becomes bigger when spreads get tighter. Hence, tight credit spreads combined with increased policy risks or a skew in the distribution of policy risks towards monetary tightening or other (fiscal) developments that increase the cost of debt funding could well be a potent trigger for a substantial correction. 

Central banks are not to blame for low interest rates

Many pundits blame central banks for low interest rates. In our view this line of reasoning gets the causality completely wrong, in much the same way as blaming one’s umbrella for the fact that it is raining. To be sure, technically speaking these pundits are correct in the short term. Central banks could push the yield curve substantially higher today if they wanted to. The real question is what would happen to yields in the medium to long term if central banks tightened substantially today. The answer is that yields would almost surely end up lower. The key element that the “blame the central bank for low rates” crowd misses is that central banks react to the underlying economic environment, which after the crisis was conducive to a large increase in net savings appetite and a large decrease in risk appetite. All these elements pushed DM space towards a lower nominal growth equilibrium over the past 10 years where the level of nominal GDP took a big step down while the nominal growth rate in many economies subsequently also lagged behind levels seen before the crisis. It is impossible to overrate the importance of this. Before the crisis nominal GDP was mean-reverting towards a pretty stable upward sloping path for more than a century. In this respect it is little wonder that mainstream economic models still assume that the economy returns to a fixed equilibrium after a shock. In this respect, the experience of the US is very interesting as it experienced a big deviation from the trend in the early 1930s during the Great Depression (see graph).

From 1933 onward GDP per capita recovered on the back of combined monetary and fiscal loosening but the improving trend petered out in the late 1930s due to premature monetary and fiscal tightening. It was around this time that Alvin Hansen began to write about secular stagnation, which is hardly surprising given the behaviour of the economy. What eventually lifted the US economy out of this trap is WWII, which amounted to a substantial fiscal stimulus.  The story of the UK is also interesting. GDP per head was clearly struggling for a long period of time after the end of WWI as the UK sought to re-anchor sterling to gold at the pre-war rate after a substantial depreciation between 1914-18. This required a combination of monetary and fiscal contraction. In the end, growth in GDP per capita was “saved” by WWII and the economy embarked on a renewed growth path. Our conclusion is that a stable upward sloping nominal GDP is by no means assured by self-correcting mechanisms in the economy. Large enough shocks can cause the economy to deviate from it permanently, and in these cases it takes a substantial combined fiscal/monetary stimulus to get back on track.

The graph only contains data until 2010, but it is increasingly clear that DM economies have been thrown off the pre-2008 track since then. It is precisely this phenomenon that has forced central banks to cut the policy rate to zero and implement QE in an effort to get back on track, or at least as close to the pre-crisis track as possible. What’s more, history also offers a clear lesson for the interest rate implications: the more we allow the economy to veer off track, the lower sovereign yields will go. This is exactly what happened in Japan, which allowed the level of nominal GDP to drift downward on balance between the mid-1990s and 2012. During this time the 10y JGB yield fell toward levels that were deemed unthinkable in the late 1990s. The prime driver here was of course the decline in inflation expectations, which eventually got stuck in negative territory. On top of this, an environment where nominal GDP persistently declines is an environment where the appetite for risk-taking is very low. This causes high savings, low investment and a large preference for investing in safe and liquid assets. This is the perfect mix for pushing nominal yields lower. A final reason that added to these trends was the expectation that the BoJ would never be able to raise the policy rate in this environment.

Some thoughts on policy mix imbalances

Now let us get back to the argument that central banks were driven much further into unconventional territory by the fact that mistakes were made in other areas of policymaking. In particular, between 2010 and 2013, DM space was treated to a dose of concerted fiscal tightening which in my view has left a permanent mark on the path of nominal GDP and also on safe Treasury yields. One can make the clearest case for this in Euroland, which suffered in a double-dip recession as a result of concerted fiscal tightening and the fact that explosive market dynamics in peripheral and banking space were allowed to spin out of control. The latter could only happen because of the complete absence of burden and risk sharing mechanisms in fiscal and banking space. We will never know the counterfactual but we believe one can make a pretty good case that EMU nominal GDP would be a lot higher today (including an inflation rate that would be closer to the target) if these policy mistakes had been avoided. In that world, private sector risk appetite would have been healthier over the past few years and the cumulative amount of ECB sovereign bond purchases would have been a lot less. As a result, Bund yields would probably have been higher, which to some extent would have spilled over to higher US Treasury yields. 

Even in the US one can make the case for persistent effects on nominal GDP and safe Treasury yields stemming from past policy mistakes. After 2010 the Obama administration was forced by the Republican majority in Congress to significantly tighten fiscal policy following the fiscal stimulus seen in 2009/10. The concomitant decrease in the structural deficit between 2010 and 2013 acted as a significant drag on US growth and undoubtedly pushed the Fed into expanding QE by more than would have been the case in the absence of fiscal tightening. Incidentally, 2010-13 was also the period of several fiscal fights (2011 debt ceiling crisis and 2013 fiscal cliff) which probably acted as an additional damper on private sector confidence. It was only in 2014 that fiscal policy in the US turned more neutral, which is why it is not much of a coincidence that this was the time that private sector demand also gained momentum and the Fed could eventually taper QE.

All in all nominal US GDP could have been higher than it is today, and because of less QE and higher past levels of private confidence and willingness to spend, yields could be higher as well. But that is all in the past now. Unfortunately, the policy mix going forward may have an unbalanced nature as well, which could be exactly what is weighing on the mind of markets right now. Of course we are talking about uncertainty about US fiscal easing and the subsequent monetary policy reaction in an environment where the economy is close to full employment. Starting with the latter:  a moderate fiscal expansion in the US economy, which is aimed at improving the supply side, would actually be a good thing. All this would push US productivity growth higher which, combined with a moderate increase in the deficit, would push r-star higher. This increase in the deficit would not be a bad thing as long as it is moderate because future tax revenues would go up and because the US is still in a situation where nominal yields are below nominal growth. As a result, the debt burden need not increase because of that. 

The reaction of the Fed in the near term would perhaps be to speed up the pace of rate hikes a bit, but this need not lead to a negative market reaction because of the improved outlook for potential growth. At any rate, the US would  in the long run end up with a better fiscal/monetary policy mix involving higher levels of r-star that would afford more ammunition to cut in a downturn. This knowledge should have a soothing effect on risk premiums today. Still, this is not the kind of fiscal easing the US will get as the current plan will probably do very little to raise potential growth and may well have disappointing effects on demand growth. Even if the demand side effect is not disappointing, this may well elicit faster Fed tightening. 

As for fiscal policy uncertainty, there has been a lot of verbal and also some price action in the markets in response to news about the tax plan. The key issue to bear in mind in all this is that not much has been decided yet. In fact, the only real certainty here is that the increase in the budget deficit over the next 10 years cannot exceed USD 1.5 trillion if the tax plan is to be approved under the FY2018 budget reconciliation.  What’s more, after 2027, the expected impact on the deficit should be zero, under what is called the Byrd rule. The House and the Senate both have their own versions of the tax plan (even though the full Senate still has to vote on its version) which eventually will have to be reconciled with each other. 

This process will not be easy and could be subject to delays. The Senate’s plan differs from the House’s in a number of crucial areas such as the structure of the individual income tax brackets, state and local tax deductions and the exact date at which the corporate tax cut will apply.  With respect to the latter, it is important to remark that US corporates have substantial leeway in their ability to shift profits over time for tax purposes. What’s more, the Byrd rule may require the expiration of corporate tax cuts after 2027, a smaller corporate tax cut, or offsetting revenue increases. None of these three is an attractive option.  A sunset on corporate tax cuts will make this even less effective because it would have to be applied a few years from now to prevent the deficit from increasing beyond 2027. A smaller tax cut is not politically attractive, now that Trump and Congress have been promising a “huge” tax cut. Finally, offsetting revenue increase would probably have to come from personal taxes, which would be very unpopular with a blocking Republican minority in the House. Meanwhile, the uncertainty for investors in corporate credits stems from two interacting issues. There is uncertainty about the size of the tax cut but the possibility of a sunset also means additional uncertainty for reported earnings in the next 10 years. On top of this there is uncertainty about the extent to which interest rate expenses will remain deductible.

Emerging markets: again tighter regulation for Chinese shadow banks

In China, the central bank announced new steps to tighten regulation on non-traditional lending activities. The new rules apply to all asset management products issued by banks, trust companies, mutual fund houses and insurance companies. It will no longer be possible for these firms to sell asset management products with a fixed rate of return, among other measures.

This should be seen in the context of the authorities’ deleveraging efforts and their ambition to increase transparency in the financial system. Already, in the past years, the shadow banking business has been tightened a lot, which is the main reason overall credit growth has moderated to 13% from 22% early 2016.

The last announcements and the large focus given on deleveraging since the 19th Communist Party congress suggest that credit growth will decline more. Fixed investment growth and housing investment in particular should feel this the most. So nothing new really, but another confirmation that Chinese growth will be driven more by consumption than investments, and that the government is serious about reducing the role of credit in the economy. Meanwhile, it is facilitating more innovation and a higher level of productivity growth through reform of state-owned enterprises and an active R&D and knowledge gathering strategy.