Have central banks missed the exit train?

This article is brought to you based on the strategic cooperation of The European Sting with the World Economic Forum.

Author: Alberto Gallo, Portfolio Manager and Head of Macro Strategies, Algebris Investments

After a decade of stimulus, central bankers have pledged to end loose monetary policy. Their attempts are failing. The Federal Reserve has been raising interest rates, pushing Treasury two-year yields to around 2.5%. However, UK, Japanese and German government bonds are still hovering around record lows, while long-end Treasury yields are flat to short-term rates. The European Central Bank (ECB) now forecasts 1.5% year-on-year consumer price inflation at year-end – yet inflation continues to flatline, with the latest figures pegging it at just 1.2%. In April this year, ECB President Mario Draghi restated his “unchanged confidence” that the bank would hit its target – but in something of a logical about-turn, he also argued that quantitative easing (QE) may have boosted potential output growth, leaving in turn “more room for keeping the ample monetary accommodation in place.” Mark Carney, Governor of the Bank of England, has also dampened expectations of a rate hike, which investors had anticipated for May. The Bank of Japan removed its 2% inflation target for 2019. The Fed was supposed to lead global policy normalisation. Instead, it appears to be moving on its own. Have other central banks completely missed the exit train?

The official explanation is that a slowdown was overdue after last year’s economic performance. But we suspect other structural factors are hindering normalisation outside of the United States. First, debt overhangs still loom large despite the overall improvement in growth and employment. The United States managed to restructure its private debt imbalances thanks to bond markets during the crisis. In Europe, Japan and China instead, the stock of public and private debt has grown larger. Eurozone and Chinese banks hold around 10% of GDP in non-performing loans. Italy’s debt-to-GDP ratio remains above 135%. UK households have borrowed up to £200 billion in unsecured consumer debt. Six percent of listed firms in the Eurostoxx 600 firms are “zombies” which cannot fully cover their interest costs, according to an analysis by Bank of America. But low interest rates have inflated property and consumer bubbles even in countries previously deemed as safe havens such as Australia, Sweden and Canada, as Stephen Poloz, Governor of the Bank of Canada, explained earlier this month. Should growth slow or interest rates rise too quickly, these overhangs threaten to hurt consumers and firms, hindering the path to normalisation.

Second, financial markets have become increasingly vulnerable to normalisation itself. The February sell-off in equity markets showed that even a small change in interest rate expectations can topple the pyramid of carry trades (which exploit differences in interest rates) resting on both QE and dovish forward guidance, as we anticipated last year. We estimate at least $500 billion of investment strategies bet on low volatility and stable correlations, adding to the $2.3 trillion in record-tight high-yield bonds and $12 trillion in government debt yielding below 1%. The accumulation of short volatility bets can generate a feedback loop, where investors unwinding their positions can feed into higher volatility, eventually hurting confidence. Third, the Trump Administration’s fiscal stimulus, the largest ever implemented during a peacetime expansion, has further increased the growth differential between the US and other developed economies. We have moved from a global synchronised expansion to an era of growth divergence between the US and the rest of the world. This means the Fed will continue to hike rates and rebuild its policy buffer, but it will also tighten financial conditions for the rest of the world, leaving little time for other developed economies to grow out of their imbalances and normalise policy. This creates a dilemma for other central banks. Following the Fed on its hike path may end the recovery too early, but leaving interest rates at rock bottom may instead result in a thin policy buffer to deal with the next slowdown, which most economists say is likely to happen within a few years. In his last press conference before leaving office, the ECB’s Vice-President Vitor Constâncio left us with a worrying clue about the future: “I have doubts that on the other hand, one can go back to the simple life of monetary policy as it used to be with very small central bank balance sheets and just policy targeting the overnight money market rate.” Monetary stimulus can only delay the problem, not solve it. Our financial system was thought out in the context of growing post-war demographics and materials-hungry industry. Today’s technology optimises resource sharing and goods substitution, while demographics are stalling, making the consensus 2% inflation target no longer realistic.

The US has showed that exiting a balance sheet recession requires a prompt reduction in debt overhangs. China’s streamlining of wealth management products as well as the ECB’s pressure to consolidate bank balance sheets are steps in the right direction. Another move is the introduction of flexible debt to absorb future shocks, including CoCo bonds for banks and growth-linked debt for sovereigns, like the European Stability Mechanism-French proposal for Greece. But the window of time is closing, and most debt overhangs remain uncontested. Without action, the risk is of a Japan-style environment of infinite QE, which will further distort resource allocation and asset prices while boosting the wealth of asset owners against younger generations.