Comment – Central banks and stranger things

It’s been a busy couple of weeks for central bank observers as the ECB, the US Federal Reserve and the BoE communicated updates on their monetary policy within just seven days. With further rates decisions by – among others – the Swedish Riksbank, the Norges Bank, the Swiss National Bank and the Bank of Japan over the last three weeks, pundits and market participants had a lot to digest.

All told, there are two take-aways from the central bank spectacle. First, central bankers might not be as dovish as markets like to believe. Second, interest rates can still go up!

The ECB delivers, but not as much as some hoped for

Ahead of the ECB’s council meeting on 12 September, it seemed like rates markets had gotten ahead of themselves in the extent to which they expected further monetary easing. This view was subsequently vindicated. On the surface, the ECB delivered by launching another QE programme and cutting the deposit rate by 10 basis points, to -0.50%. However, at the same time it said it would introduce a tiering system to central bank deposits, which softened this rate-cutting measure. Furthermore, while the open-ended QE programme represented a boon for state finances, its scale seems smaller than that of the previous edition. The communication that accompanied these additional measures constituted an admission that monetary policy can only do so much and that it was now up to governments to ease fiscal policy in order to stimulate growth.

Markets realised that this wasn’t nearly as dovish as they had thought (or hoped for) and reacted promptly. 10 year swap rates rose from -0.25% to -0.05% the day after the ECB meeting, as a reminder that it can pay off to neutralise some of your risk ahead of key events.

The Fed and markets are split

Almost one week later, on 18 September, the Fed cut the target range for its fund rate by another 25 basis points, to 1.75-2.00%. This was in line with market expectations but insufficient for President Trump, who took to Twitter lambasting the Fed and Powell for a lack of “guts” and “vision”. Although the US central bank delivered on market predictions, its announcement was by no means a non-event. First, there appear to be divisions among the FOMC members, with some having voted to keep rates on hold. Moreover, whereas markets attach 50/50 odds to the funds rate being below 1.5% by 2020, the Fed’s internal dot plot suggests that 1.5% will be the end of this easing cycle. In the past, markets have tended to underestimate the Fed’s hawkishness. This could be another one of those moments.

Brexit keeps the BoE’s hands tied

The day after the Fed, it was the Bank of England’s turn. Unlike its US and Eurozone counterparts, it left its base rate unchanged, merely hinting that persistent uncertainty might warrant a rate cut at some point. Just like so much in the UK economy right now, monetary policy is highly dependent on the Brexit outcome, and hence the Bank prefers to wait and see. Meanwhile, markets are signalling confidence that the risk of a no-deal Brexit has receded. The GBPUSD exchange rate and 5-year GBP swap rates have been climbing in lockstep since parliament voted to block a “no deal” departure from the EU on 31 October.

Stranger things

At a time when most central banks find it difficult to hike rates in light of low growth and inflation, it is worth pointing out that some policy makers have tightened monetary conditions due to strong economic activity. Norway’s central bank raised its policy rate for the third time in 2019, from 0.75% to 1.50% and claimed it expected to hike further in late 2019 or early 2020. Strong capex in the country’s oil industry appears to be giving the Norges Bank confidence in the domestic economy’s ability to withstand higher interest rates.

Elsewhere, people have picked up on a series of US dollar crunches that have occurred in recent weeks, with spikes in repo rates above 10% and the upper bound of the Fed’s target funds rate breached in lending transactions. In order to combat these sudden liquidity squeezes, the US central bank had to intervene. While strange and somewhat worrying, it seems that several unrelated and innocuous factors, such as corporate tax payments coinciding with strong US treasury issuance, combined to cause this short-lived shortage of USD cash. That said, many were unsettled by the parallels with the onset of the financial crisis.