Some day this crisis will end. When, and at what human and economic costs, remain big unknowns. But when markets return to something like normality, investors are likely to find a fundamentally altered political and economic landscape: one in which the role of monetary policy has shifted from primary to secondary importance.
For some time I have talked of this impending paradigm shift, referring to it as the end of monetary dominance and the return of fiscal reliance. But the Covid-19 crisis has made this a reality. Indeed, March 2020 will go down as one of the most dramatic months for policymaking in modern memory.
The G10 policy rate is now zero — a record low. Quantitative easing is back, at a broader and larger scale than seen before. Other measures are in place to help with the functioning of markets, giving us a whole new round of acronyms to get used to.
But the shift in fiscal policy has been even more dramatic. In early March, the US fiscal response was $8bn, which the White House said was too much. The figure is now $2tn, 10 per cent of gross domestic product. Germany, too, has announced a huge supplementary fiscal package which will be funded by €150bn of new debt issuance, essentially ending the country’s “black zero” policy of balanced budgets and no new borrowing. In truth, tracking the fiscal cost is irrelevant. This is governments’ “whatever it takes” moment.
This new framework will have huge ramifications for markets. Let me suggest four. First, a world more reliant on fiscal rather than monetary policy should mean higher bond yields, steeper bond curves and higher market risk premia, all else being equal. All three trends were on display in the past month. The aim of monetary policy in the past decade was to lower bond yields, ease financial conditions and move investors up the risk curve. Fiscal policy targets the real economy more directly and is funded through large borrowing.
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Related to this is the second effect: the Covid-19 crisis has taken a big step toward policy co-ordination along the lines of modern monetary theory, which says that debt mountains or giant budget deficits do not matter for sovereigns borrowing in their own currencies. Huge fiscal deficits will be funded at least in part by central bank purchases. That means that when markets settle, volatility in interest rates should be the first to fall, but probably not to the record lows seen before the crisis.
The move toward MMT also means upward pressure on inflation. Inflation-linked bond markets have been battered by the crisis, but I cannot help but think that the direction of travel for inflation in a world of massive fiscal deficits funded by central bank bond-buying is higher, not lower. Finally, it also makes stocks look much more attractive, compared with bonds. Equity risk premia are now near multiyear highs in most markets. Relative equity valuations look even better when you factor in the impending surge in the supply of bonds.
A third theme likely to gain traction is the relative deterioration in government balances in western Europe and the US, compared with many emerging market countries. It is early days, but a current feature of the Covid-19 crisis is that it has affected western Europe and the US much more. Emerging market assets have been largely untouchable in recent weeks, but this balance sheet trend should eventually matter, and will be a net positive for emerging markets.
Finally, one encouraging trend in the Covid-19 crisis response has been policymakers’ explicit attempts to limit the impact of new policies on banks. Banks need to be a central part of the solution, but will be hit hard by the crisis. Knowing this, European policymakers — and the European Central Bank especially — have shown strong reluctance to reduce the policy rate further. Other bank-friendly measures include regulatory capital relief, funding for lending schemes at attractive levels and cancellation of bank stress tests. Every little thing helps.
Monetary policy ammunition was already low before the Covid-19 crisis and is now largely spent, having lost much of its potency as a standalone instrument. The way markets shrugged off two unscheduled interest rate cuts from the US Federal Reserve should be evidence enough of this shift.
In this new landscape, monetary policy will play a supporting role: helping to fund the inevitable surge in fiscal deficit-driven government bond supply in the months ahead.
Jim McCormick is global head of desk strategy at NatWest Markets