US economy

Gauging the switch from monetary to fiscal stimulus


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Few expect any surprises from upcoming central bank meetings, given how the year has seen the fastest pace of policy easing since the financial crisis. 

This week’s meetings of the Federal Reserve and the European Central Bank will send a message that monetary policy will stay in easing mode for quite a while, supported by their expanding balance sheets.

Ben May at Oxford Economics, via the following chart, notes:

“The world’s central banks have delivered a broad-based policy easing that has been larger than during the previous two mini-downturns of the current cycle.”

He also highlights:

“The proportion of emerging market central banks that have recorded policy rate cuts over the past six months is at levels previously seen this century only during periods of major global economic stress.”

Against this backdrop, low government bond yields and slumbering market volatility has helped spur strong equity and credit returns this year, fanning concerns that performance is running well ahead of the curve. Indeed, 2020 outlooks tend to exhibit caution along the lines of “limited upside” given lofty valuations in some equity sectors and expectations of a modest bounce in corporate earnings growth over the next 12 months.

As central bankers sit back after enacting easing policies this year, there be will scant attention paid to the risk of overheating markets that threatens financial stability, while any reference to the limits of monetary policy at this week’s Fed and ECB press conferences will probably provide another opportunity for Jay Powell and Christine Lagarde to reiterate a clarion call for fiscal easing. 

Expectations for greater fiscal spending has played a role in arresting some of the decline seen for core 10-year bond yields this year. There has been a modest rise in yields from their lows of August. In fact, on Tuesday the Japanese 10-year neared zero for the first time since March before buyers emerged.

For various reasons, fiscal stimulus loiters beyond the horizon for both the US and Europe. A split US Congress and the coming election year reduces the likelihood of fiscal easing, while Germany shows little appetite of truly opening the spending spigot wide. 

In contrast, Japan has rolled out spending plans for the next 15 months, via a ¥13.2tn ($121bn) package to repair typhoon damage, upgrade infrastructure and invest in new technologies. Funding such spending is easy at current low rates; the challenge lies in finding projects that boost long-term growth and productivity for the economy. 

A potentially bigger fiscal push among leading economies looms for the UK, particularly in light of data on Tuesday that showed the British economy had stalled at the start of the current quarter, as shown by this chart via the FT’s Valentina Romei. 

Column chart of Rolling 3 month, % change over previous three months  showing Three-month UK GDP did not grow in October

Still to come for the UK is the task of leaving the EU and then negotiating a new trade agreement with the country’s largest commercial partner. Given the current fading macro backdrop, the case is growing stronger for the UK to adopt significant fiscal stimulus. 

As Steven Englander at Standard Chartered notes:

“In the current cycle, we expect the UK to be the first to turn to fiscal stimulus as it tries to deal with the consequence of Brexit.”

Opinion polls indicate the likelihood of a Conservative party majority in the House of Commons after the votes in the general election on Thursday are counted. Although the announced spending plans by the Conservatives are eclipsed by those of the opposition Labour party, it’s not hard to see a big fiscal push on the horizon should Boris Johnson remain at Number 10 Downing Street. 

John Hardy at Saxo Bank notes: 

“While Johnson’s spending promises look modest now, we suspect a Johnson government will get far more aggressive on stimulus — both in terms of tax cuts and spending in light of weak UK economic data into year-end.”

Low UK government yields provide scope for greater borrowing by the next government, but as Silvia Dall’Angelo, senior economist at Hermes Investment Management, notes:

“While a more structured approach to fiscal policy — allowing for an effective counter-cyclical response and built to tackle long-term challenges such as supporting productivity growth — would be appropriate, it is not clear that the parties’ manifestos are inspired by these principles.”

She also warns how the “recent deterioration in net borrowing trends, slowing growth and the accounting reclassification of some items (most notably student loans)” has already weakened “the starting point for the UK public finances” before the spending shackles are released.

“While the UK could soon become a lab to experiment on fiscal policy, there might be too much faith placed in the spending cure.”

There is another consideration for investors and policy officials if the UK embraces fiscal stimulus: the role played by the Bank of England and whether another round of quantitative easing ensues. 

Standard Chartered makes this point: 

“Simultaneous QE is not guaranteed, but policy makers are likely to implement it if there is no clarity on how long the Brexit-induced slump might last. Monetary support for fiscal expansion can end when economic or inflation targets are met.”

Central banks have up to now not crossed the line of monetising government debt, but they are heading down that road, or, as Bank of Japan governor Haruhiko Kuroda recently opined:

“If fiscal policy becomes more aggressive with interest rates at appropriately low levels and continued easing in place under the current yield curve control policy in an overall policy mix, fiscal policy will be more effective.”

The BoJ governor has also reiterated that monetary easing is focused on pushing inflation higher, not financing government spending. This likely remains the case unless global growth and interest rates sink lower from here and a harder landing ensues.

Standard Chartered writes:

“Central banks have avoided discussion of permanent balance-sheet expansion where all or most of the asset expansion is government debt, and have denied intentionally financing fiscal expansion. But if inflation and rates are near the zero bound (or below), it makes sense to get the most inflation and output ‘bang for the buck’ from fiscal and monetary policy.”

Via QE and yield curve control policies, such a step by central banks may well work in the near term, but also heightens the risk of bond and currency market turmoil, a conclusion reached by Standard Chartered. The banks reminds us: 

“Investors are likely to be less confident that the policy-making process would be able to halt the stimulus soon enough to avoid an inflation and demand overshoot.”

Quick Hits — What’s on the markets radar

Brace for a bout of US equity volatility is the warning when looking at current futures positioning. Here’s a chart showing a record level of so-called net shorts in Vix futures from UniCredit.

Investors have long sold Vix futures (based on the Cboe’s measure of implied volatility for the S&P 500 over a 30-day period) as the era of central bank liquidity and low bond yields has fostered a steady rise in equities and kept volatility in remission. Even eruptions of equity market selling, as seen in February 2018 and late last year, have only briefly interrupted this long-term trend. The recent expansion of the Fed’s balance sheet as it seeks to relieve pressure in the short-term funding or repo market has clearly encouraged investors to expect that low market volatility will continue. 

Still, there may a shift on the horizon. UniCredit’s Christian Stocker notes: 

“History has shown that, in an environment of sluggish or slowing economic growth (which we expect will be the case, particularly in the US) and, as a result, decreasing growth in company earnings, implied volatilities in equity markets tend to increase. Against this background, the current high degree of investor complacency in the US could be a harbinger of bigger equity-market swings in the next few months.”

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I’d love to hear from you. You can email me on michael.mackenzie@ft.com and follow me on Twitter at @michaellachlan.





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