From all that we observe in the United States (Federal Reserve), Europe (European Central Bank), Japan (Bank of Japan), and other jurisdictions, monetary policy now consists of three basic, interconnected variables. They are (1) central bank balance sheet size, (2) balance sheet composition and duration, and (3) policy interest rates set mostly in the short term but also possibly in the intermediate and longer term. This policy tool set is a massively different system from what was studied for decades and applied for more than half a century. Today’s world no longer reflects the monetary dynamics envisioned by Milton Friedman.
Let’s look at this configuration of policy tools in the sequence outlined above and then integrate it into portfolio management issues.
A central bank can manage the size of its balance sheet using one or more versions of quantitative easing (QE). The central bank creates money out of thin air and uses it to purchase assets. The newly created money circulates briefly in the banking system of the country or jurisdiction and quickly ends up deposited at the central bank in the form of an excess reserve or variation on the same. In many instances the money circulates for only a few hours. This circularity is a reason that there is little or no inflation stimulated and also little or no employment initiated. The central bank does alleviate pressure on interest rates derived from the debt issuance of governments, and the central bank does expand liquidity in the financial system. Under many circumstances the excess liquidity actually creates a “liquidity trap.” That term describes the present situation in many countries: additional QE results in very little economic change.
The composition of the central bank’s balance sheet assets is another policy tool. Assets can be longer- or shorter-term. The Fed varies narrowly between sovereign debt (US Treasury bills, notes, and bonds) and federally backed mortgages. The Fed currently restricts its assets to those that are directly or contingently guaranteed by the US government. Internet stories about the Fed secretively buying stocks, corporate bonds, or municipal bonds are simply not true.
In addition to sovereign debt, we see broadening use of collateral and assets by some central banks. In Japan we also see purchases of a stock ETF and REITs. The BOJ announces its policy of asset acquisition and then follows that policy. It is important to view this policy as buy and hold. There is no official indication that the BOJ ever intends to sell. Public selling of any asset by a central bank would immediately result in a falling price. Even the Federal Reserve has stated it does not intend to sell its holdings. It may allow them to run off as they mature, but even the pace of runoff is unknown at this time. For now, the Fed is at neutral regarding the size of its balance sheet. It took years for the Fed to come to a full stoppage of QE and achieve a neutral stance regarding asset size. It is likely to take more years for the Fed to actually allow its balance sheet to shrink.
The European Central Bank is considering private-sector loans and additional types of bonds to add to the sovereign debt and covered bonds it holds. The most recent action (December 3) added the European version of municipal bonds to their mix. The ECB is actively exploring variances in its asset mix and additional collateral for good reason. The ECB must do this since it has to implement its policy through the national central banks of the 19 Eurozone member countries. The debt and asset structure in each of those countries differs from the others. Germany, for example, is the largest economy in the Eurozone but Italy is the largest debtor.
At each of these central banks, asset and collateral selections change the duration of balance sheet assets and the composition and willingness of the central bank to take on risk. Thus there is variance among the countries affected. Let’s think of comparing their approaches as we would compare several portfolios with different asset allocations. Obviously, central banks will react differently to market-driven events.
The last policy tool is the setting of policy interest rates. Short-term interest rates can be set anywhere a central bank wants. At the Fed, the policy interest rate is likely to soon be raised by one-quarter of one percent, which will be the first hike since the financial crisis. In Japan, the policy rate has been at or near zero for about two decades. In Europe, we see the currently negative interest rate becoming more negative. That ECB negative rate course has been followed by non-Eurozone countries like Switzerland, Sweden, and Denmark. We expect that downward movement in non-euro countries to follow the December 3 announcement by the ECB. The ECB suppresses interest rates throughout the European Union (in countries like Poland) and in nearby jurisdictions.
In Europe there are growing indications of economic malaise and flatlined inflation. The European Commission has warned Austria, Belgium, Estonia, Finland, France, Germany, Ireland, Italy, the Netherlands, Portugal, Slovenia, and Spain regarding imbalances and rising economic risk. Click here to read, “EU Warns 12 Euro-Area Nations Including Germany Over Imbalances.” Policymakers are announcing their worries about deflation, slow growth, high debt levels, and other stubbornly negative indicators in European economic news. Non-Eurozone countries share similar concerns, such as those expressed in the UK, Sweden, and elsewhere throughout the second-largest capital market block in the world. That block consists of over 500 million people who are reasonably affluent and are a powerful force in the world’s economic growth.
In addition to the central banking inventory above, we see rising savings rates worldwide. Rising savings rates are partially induced by demographic changes that are not alterable by central bank policy. Aging people are worried about their retirements, longevity, and the incomes they will need to support themselves. Therefore, they respond by saving more. Low interest rates and resultant financial repression also raise the savings rate. The latest round of statistics on increased saving was recently released in the United States. The personal saving rate rose to 5.6% of disposable income, the highest level since December 2012 (Wall Street Journal, 11/27/15).
We see rising savings rates globally. In Asian economies, expressed as current account balances, savings are rising in China, Japan, and emerging economies. BCA Research compiles that data for an aggregate of 17 emerging countries. Despite negative interest rates, the saving rate continues to rise in the euro area as well.
There is a debate about higher or lower interest rates causing the savings rate to rise or fall. Some argue that lower or negative policy rates encourage behavioral changes that redirect savings into more risky investments and that the effect is stimulative. Maybe so. But others argue that the financial repression effected by reducing earnings on savings causes fear and that people then tend to save more since the return on their savings is altered to a lower number or to a higher risk than they would otherwise want to take. While the debate rages on, the major thrust around the world, outside the US, is toward zero or negative interest rates.
The Fed now struggles with the decision whether to raise the US short-term policy interest rate by 0.25 of 1% at their December 2015 meeting. At the same time, rising savings rates, lower global short-term interest rates, negative European interest rates, and more than $2 trillion in European sovereign debt now trading at a negative yield come into focus. All these factors lie beyond the Fed’s control but certainly exert an influence, and the likely outcome is a stronger dollar.
We would like to see the Fed raise that short-term rate by 0.25 of 1% and get the first hike behind us. We believe the stock market will tolerate that hike and favor an adjustment process away from the distortions that the zero-interest-rate boundary generates in financial markets. Market agents cannot accurately project an outcome when the interest rate is zero: they do not know what the market-based influences will be once the interest rate moves away from zero. But once something is priced above zero, it is possible to determine choices made by market agents without the distorting effect of the zero. It only takes a few basis points to restore the decision-making process to market agents.
In Europe, circumstances are different. Those circumstances include use of the negative interest rate that expands the size of the central bank’s balance sheet, the composition of the assets on that balance sheet, and short-term policy rates declining to new and even lower negative levels. We expect the European experiment with negative rates to continue for several years. Draghi has committed to 2017 and left the door open for longer. We think negative rates will be bullish for asset prices but only minimally helpful for economic growth or inducing inflation. The demographics and savings rates work against the central bank. The ECB is using blunt tools to try to stimulate Eurozone economies that are struggling deeply.
In sum, the outlook remains for very low interest rates throughout the developed economies of the world. The Bank of England, Bank of Japan, European Central Bank, and Federal Reserve compose the G4, the overwhelming force in global monetary policy. The G4 defines worldwide reserves in monetary terms, the new addition of China’s yuan to reserve currency status notwithstanding. The G4 economies are averaging near zero in short-term interest rates and within a range of 1%–2% in long-term interest rates. The pressure on those interest rates is lower, not higher.
We think asset pricing has an upward bias. For that reason we remain optimistic about stock markets. For foreign markets we prefer currency hedges to protect against devaluations of those currencies, as we expect the US dollar to strengthen.
Lastly, we expect huge increases in volatility. Volatility is disconcerting. And volatility allows investors to be opportunistic. At Cumberland Advisors we remain nearly fully invested in our worldwide ETF portfolios. We continue to favor spread product in the bond market, especially in the tax-free and taxable municipal bond markets of the United States.