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Time for central banks to wind back emergency policies

Written by Anthony Golowenko, Portfolio Manager
19 October 2021,
  7 min read

  • Rising global vaccination rates and an improving outlook are causing central banks to change their tone, and also change policies, in some cases.
  • The US Federal Reserve is hinting at ‘tapering’ its current US$120 billion a month asset buying program. To reassure financial markets, the US Federal Reserve has made clear that there is no direct link between possible ‘tapering’ and interest rate hikes.
  • Active investors should welcome ‘tapering’ as it may contribute to discriminating between genuinely quality assets against those that merely have a quality veneer.
  • We believe that our tried and tested ‘participate and protect’ investment approach is up to the task of steering clients’ portfolios through changing market conditions.

Question: how long should central banks continue with emergency policies?

Hint. The answer isn’t indefinitely.

The world’s central banks, led by the US Federal Reserve (“the US Fed”), put on their fire-fighting gear in April last year, and rolled out extraordinary policies to support businesses and economies hit by COVID-19 shutdowns.

Already low official interest were cut even more, taking them, in some cases, to below zero1. Lending programs have enabled banks to borrow at especially low interest rates, and ‘quantitative easing’, where central banks buy bonds to lower long-term interest rates, returned with vigour after first appearing during the 2008/09 GFC.

Emergency settings made sense when the pandemic had a vice-like grip, but roughly 18 months on, the world’s a different place, making the case for a winding back of policies, or at least making a start on doing so.

Portfolio Manager update: vaccines and economic progress

Progress is being made both locally and globally against the virus, and there’s plenty of evidence of recovery in many economies.

Vaccination rates — a combination of a first shot as well as double jabs — range from 62% in Australia, to 76% in Canada, 71% in the UK, and 63% in the US2. Developing countries too are picking up the pace on vaccinations with China at 76% and South Korea 74%, for example3.

More countries are announcing roadmaps out of restrictions.4

To be clear, even after vaccinations, there’s going to be an ongoing guerrilla war between medical science and the virus.

Medical professionals have been informing us that we are going to have to learn to live with COVID-19, in some form. There is ever-improving scientific understanding of the virus and pandemic-management, but the sobering reality is that medicine has only ever eliminated one disease, smallpox.
Central banks, like financial markets, are forward looking and what’s ahead are reasons for cautious optimism.

Take one upbeat forecast, for instance.

“S&P Global Ratings’ forecast global corporate capital expenditure will jump by 13% this year, with growth in all regions and broad sectors — especially in semiconductors, retail, software and transportation.”5

For its part, the Reserve Bank of Australia (RBA) recently noted that “output in many economies was expected to have recovered to, or surpassed, pre-pandemic levels”6, while US Fed chair Jerome Powell commented that “indicators of economic activity and employment have continued to strengthen.”7

Portfolio Manager update: what central banks are thinking and doing

Central banks are responding to what they’re seeing, with a change of tone, as well as gradual changes of action, in some cases.

Norway’s central bank, Norges Bank, became the first advanced country central bank to raise post-crisis interest rates taking them from zero to 0.25%.8   Closer to home, the Reserve Bank of New Zealand (RBNZ) recently increased the country’s official cash rate to 0.50%.9

There are market expectations that the Bank of Canada and the Bank of England will start increasing their countries’ official interest rates around mid-2022.10

While certainly not in the category of ‘knocking one’s socks off’, we believe these are meaningful signals that other central banks are preparing to incrementally change course and move beyond emergency policy settings.

Portfolio Manager update: US Fed sensitive to financial markets

As ever, the US Fed gets the most attention as what it says and hints at, let alone actions, can move markets sharply.

Investors may recall the infamous May 2013 “taper tantrum” when the then Fed chief Ben Bernanke triggered a jump in US 10-year bond yields (bond prices fell)11  when he testified before Congress of the Fed’s intention of winding back its asset purchase program.

That jolting episode would have been on Mr Powell’s mind when he recently emphasised that no changes to official US interest rates were likely until next year. He has, however, ever so gently, flagged that the Fed is thinking of tapering its current US$120 billion per month asset buying program.12

Just in case there’s a risk of financial markets drawing a link between ‘tapering’ and interest rate hikes, he repeated that the Fed’s asset purchases “will not be intended to carry a direct signal regarding the timing of interest rate lift-off.”13  Instead, the Fed “will use a different, more stringent test to determine when to lift rates.”14

The RBA’s thinking is consistent with the Fed’s, with Australia’s central bank intimating that it too is contemplating tweaking its asset buying program, which is now running at $4 billion a week, down from the earlier $5 billion a week.15

Again, like the US Fed and its global counterparts, potential RBA policy changes should be viewed against the backdrop of an improving economic outlook that is now meaningfully distant from last year’s COVID-shock.

Rather than fearing the possible wind-back of emergency policies, now that the worst of the economic disruption appears to have passed, we think investors should welcome them. It means things are gradually normalising. Conditions are brighter. The recovery path seems more certain.

Portfolio Manager update: investment market impacts

Central banks’ massive asset buying programs have succeeded in suppressing long-term interest rates, and so we think that in and of itself, modestly ‘tapering’ these programs will likely have limited effects on long-term interest rates.

That said, investors will want clarity on the size and timescale of the tapering being mulled over, as well as flow-on effects on eventual interest rate lift-off. The hiatus between now and when that point is reached could create some near-term uncertainty and an uptick in market volatility.
Though rises in commercial interest rates may be small, they may nonetheless contribute to ‘separating the wheat from the chaff.’

In our view, unusually low interest rates have boosted financial asset values across the board (except cash) often in an undiscriminating way. Said differently, low interest rates have been like a rising tide that lifts all boats.

Thing is, not all assets and investments are equally good, and not all deserve to be lifted.
Ultra-low interest rates have also encouraged excessive borrowing and risk-taking, which creates economic vulnerabilities. Just think of galloping Australian house prices and debts that people have taken on.

Perhaps small rises in market interest rates may encourage a rethink and modify behaviour.
As active investors, we have a responsibility to critically discriminate between assets and investments that deserve support, versus those that don’t.

Near-term volatility aside, if tapering ultimately helps in that process, that would be a positive step, from our perspective.

Portfolio Manager update: ‘Participate and protect’ through changing markets

There is no single right way of investing. However, our investment approach, which we describe as ‘participate and protect,’ has steered our clients’ portfolios through changing marketing conditions since 1985.

‘Participate and protect’ has been tried and tested in market upheavals like last year’s COVID-crash and the GFC, amongst others.

It aims to deliver strong risk-adjusted returns by giving our clients access to the higher return potential of growth assets, including shares, private equity, and infrastructure, while looking to protect them against the risk of market downturns through innovations including sophisticated options strategies, and more income-orientated specialised alternatives.

 


 

Important information

1International official interest rates, RBA Table F13 - Reserve Bank of Australia, https://www.rba.gov.au › statistics › tables › x, accessed 28 September 2021.

2Coronavirus (COVID-19) vaccinations, ourworldindata.org/covid-vaccinations?country=AUS, accessed 28 September 2021.

3Ibid.

4The latest updates on international gathering and travel restrictions, Elise Schoening, Lizzie Wilcox, 27 September 2021, https://www.northstarmeetingsgroup.com/coronavirus-countries-cities-reopening-COVID-19-new-cases, accessed 28 September 2021.

5Big business shines a ray of hope, Malcolm Scott and Enda Curran, 13 September 2021, https://www.bloomberg.com/news/newsletters/2021-09-13/what-s-happening-in-the-world-economy-companies-invest-for-post-pandemic-world, accessed 28 September 2021.

6Minutes of the Monetary Policy Meeting of the Reserve Bank Board, 7 September 2021, https://www.rba.gov.au/monetary-policy/rba-board-minutes/2021/2021-09-07.html

7Transcript of Chair Powell’s Press Conference September 22, 2021, 22 September 2021, https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20210922.pdf, accessed 28 September 2021.

8Norway initiates move to a higher interest rate world, Alex Gluyas, 24 September 2021, https://www.afr.com/markets/debt-markets/norway-initiates-move-to-a-higher-interest-rate-world-20210924-p58ufe, accessed 28 September 2021.

9Monetary Stimulus Further Reduced - Official Cash rate raised to 0.50 percent. Reserve Bank of New Zealand, 6 October 2021, rbnz.govt.nz/news/2021/10/monetary-stimulus-further-reduced-official-cash-rate-raised-to-050-percent, accessed 8 October 2021.

10Norway initiates move to a higher interest rate world, Alex Gluyas, 24 September 2021, op cit.

11Yields move in opposite direction to prices. Thus when bond yields rise, it means their prices fall. “U.S. 10-year yields rose from a low of 1.4% in 2012, to 3%” during the taper tantrum. Taper tantrum? Only if somebody wakes the U.S. bond market. William Watts, 7 June 2021, https://www.marketwatch.com/story/taper-tantrum-only-if-somebody-wakes-the-u-s-bond-market-11622842086 accessed 28 September 2021.

12Transcript of Chair Powell’s Press Conference September 22, 2021, 22 September 2021, https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20210922.pdf, accessed 28 September 2021

13Ibid.

14Ibid.

15Minutes of the Monetary Policy Meeting of the Reserve Bank Board, 7 September 2021, https://www.rba.gov.au/monetary-policy/rba-board-minutes/2021/2021-09-07.html

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