Investors must brace for extraordinary policy reactions

In recent weeks, central banks have shown a willingness to reopen the monetary spigots to keep the economic show on the road. This raises some big questions: are we on the cusp of a new wave of monetary experimentation? If so, how significant will the economic impact be? And are investors ready?

The next stage of monetary innovation may see central banks taking policy rates well below zero and potentially even extending asset purchases from government and corporate bonds, to corporate equity.

Neither form of policy extension is based on clear economic merit. It is hard to pass on negative interest rates to households; they have the option to withdraw cash and keep it under the mattress. In practice, negative interest rates simply act as a tax on both banks and businesses.

Equally, buying corporate bonds and equities risks all manner of problems, as it has the potential to worsen inequality by inflating asset prices. And it can wreak long-term damage on the economy through warped incentives. Central banks passively holding stocks and bonds do not encourage company managers to run their businesses more effectively.

Still, several countries’ central banks appear set to embrace this new wave of monetary experimentation, adopting increasingly questionable policies in an attempt to match the efforts of their neighbours and prevent their currencies from appreciating. They will be under pressure to win — or at least not lose — the currency war.

Multilateral forums such as the IMF are designed to prevent such an outcome. But under the current US administration, their effectiveness appears diminished. We should expect more examples of collective failure such as this.

If the new monetary policies are not obviously expected to boost private sector spending, should investors expect the overall impact on growth and inflation to be even more muted than the last batch?

Not if governments are more willing to spend. Earlier in the decade, finance ministers across the developed world were reeling from the exorbitant levels of debt that emerged after the financial crisis. Bringing those debt levels down was the policy priority, for fear that interest rates would otherwise spiral.

The result was that central banks were operating against an enormous headwind of fiscal austerity. It is very difficult to generate inflation when a sizeable portion of the workforce in the public sector is under a multiyear pay freeze, for example.

But interest rates have proved largely impervious to levels of government debt. Debt levels in the developed world have either stayed high or continued rising, yet half the bond market across this group has a yield below 1 per cent — and almost one-third is negative. This would suggest central bank purchases and regulatory pressure on financial institutions to hold a higher stock of government bonds have proved effective in absorbing debt while keeping interest rates low.

Governments, it appears, can acquiesce to their austerity-fatigued populations, without the fear of higher interest rates. We are already seeing a move towards greater co-ordination between governments and central banks: the Bank of Japan has recently hinted it will maintain its commitment to yield curve control (anchoring 10-year rates near zero) regardless of the fiscal backdrop. The Japanese government is surely tempted to cancel its planned rise in sales tax.

In the event of a new downturn, a co-ordinated monetary and fiscal push might be an entirely sensible policy prescription. However, there are considerable risks if populist governments have more ambitious plans. An unelected central bank cannot dictate the form of fiscal expansion, yet it would surely be much more comfortable with greater infrastructure spending than a reduction in the pension age.

There are two implications for investors. First, we must stop believing that the government bond markets tell us much about the economic outlook. A 10-year US Treasury yield at 2 per cent tells us the Federal Reserve is planning to buy a larger share of that market, not necessarily that the US economy is careering towards a deep recession. The 1940s and early 1950s demonstrated the ability of a determined government to anchor interest rates. The 10-year Treasury yield was held steady at roughly 2.5 per cent despite nominal gross domestic product at times growing at a double-digit rate.

Second, we should spend a lot more time thinking about tail risks rather than likely scenarios. One possible risk is that this monetary and fiscal collusion ends up rather heavy-handed and inflation does re-emerge in a more meaningful sense. This may or may not pose a major risk to fixed-income markets. The presence of such a dominant market player in the form of the central banks means that these markets may remain detached from fundamentals. After four decades of declining inflation, investors might do well to begin adding inflation-protected assets, be it real assets or inflation-linked bonds.

We are in a time of extraordinary politics. Investors must be prepared for some extraordinary policies.

Karen Ward is chief market strategist for Emea at JPMorgan Asset Management