Central bank watcher: Good citizens

Although risk markets, seemingly, have taken a more benign view of the future course of the global economy, the three major central banks, the US Federal Reserve, European Central Bank (ECB) and Bank of Japan (BoJ), continue to strike a dovish tone – cognizant of the lingering downside risks stemming from the virus’ trajectory and second-round effects on labor markets and business investment. Through their government bond buying programs, they ensure that sovereign yield curves effectively remain in lockdown, despite the large wave of issuance hitting markets – and summer holidays notwithstanding. In short, through their coordination with fiscal policy, they continue to act as good citizens.

Only the People’s Bank of China (PBoC) has switched to a less dovish stance. But we suspect it may be too early to throw in the towel on further policy loosening in China, beyond some targeted easing measures aimed at SMEs. Also, we note the PBoC, after the back-up in yields, has stressed the need for coordination with fiscal policy.

Looking ahead, our scenarios for policy rates still see the biggest scope for rate cuts in China, although the recent uptrend of the euro, if it persists, could put a further ECB rate cut realistically on the table.

The message from the Fed has been pretty consistent recently and can be summarized as follows. The trajectory of the virus will be the single most important determinant of economic conditions. The policymaker is determined to support the economy, but at this point further fiscal stimulus will be much more effective than additional monetary action. A new stimulus bill is not a nice to have; it is essential to prevent both an income gap and a blow to consumer and producer confidence. Negotiations in Congress are ongoing, but have become quite politicized. Still, we expect an agreement on a bill, as this is in the interests of both Democrats and Republicans, especially in the light of the upcoming elections.

On rates, the message is clear. Members of the FOMC are united in their intention to keep rates on hold for a long period. Low inflation helps to maintain this stance, but there is also a willingness to accept an overshoot of the inflation target. A likely next step in rates policy is a strengthening of the Fed’s forward guidance.

The ECB’s July Governing Council meeting confirmed a ‘wait and see’ stance, and was mainly used to underline the new measures that were taken in June: the ECB will continue purchases under the pandemic emergency purchase program (PEPP) “until at least the end of June 2021”, while principal payments from maturing PEPP holdings will be reinvested “until at least the end of 2022”. Moreover, the key policy rates, including the -0.50% deposit facility rate, were left unchanged, while the forward guidance that rates could end up at “lower levels” was maintained. What is more, the ECB “continues to stand ready to adjust all of its instruments”, as appropriate.

Recent appreciation of the euro, to trade-weighted levels last seen in 2014, is estimated to shave off 0.2ppt of inflation one year out. There is little evidence so far of it weighing on longer-term breakeven rates. But, at the margin, we view the euro strength as increasing the chance of additional ECB support. It will be interesting to see how the new staff projections for Eurozone inflation, due at the next September meeting, pan out. As for the rates outlook, we would therefore continue to assign a reasonable probability to a further 10bps cut in the deposit facility rate by year end, as is also discounted by markets.

The PBOC’s Q2 monetary policy report (MPR) released in early August was arguably less dovish compared to the Q1 edition, echoing the (less dovish) statement from the July Politburo meeting. It seems authorities are now much less concerned about the economic outlook, and prefer the path of targeted easing aimed at lowering bank lending rates particularly for SMEs.

Our economic barometer for China confirms that the recovery has continued. However, consumer spending still lags, as the July retail sales data demonstrated. Nonetheless, we find the 7-day interbank fixing repo rate, to which non-deliverable interest rate swaps (NDIRS) are tied, and 3-month SHIBOR having settled above the PBoC’s 7-day reverse repo rate.

For two reasons, we see the risks to our baseline view as skewed to even lower money market rates. First, risks to the economic outlook remain tilted to the downside. Secondly, underlying inflation seems to be on a downward trend, which risks pushing up real, inflation-adjusted interest rates.

The BoJ’s recently communicated economic assessment is slightly above that provided in the June statement, amid signs that economic momentum has hit the bottom. While the domestic situation remains severe and fluid, the BoJ observed that economic activity is gradually picking up again. It offered a notably more positive view on consumption, which it characterized as recovering. It also added that economies elsewhere appear to be turning upward. At the same time, it scaled back its inflation expectations, describing these as weakening.

While the BoJ had predicted in its April Outlook Report that the domestic economy would strengthen from the latter half of the year, it stated at the June meeting, for example, simply that “the economy is projected to keep improving further”, without stating a specific period. The BoJ also made clear that its forecast is based on the assumption that there would be no large-scale second wave of infections.

Monetary policy will continue to depend on the course of the Covid-19 pandemic, but we think the BoJ will maintain its current policy as long as economic activity continues its slow and erratic recovery.