Central bank watcher: Rates in lockdown for longer

With the outbreak of the coronavirus hitting the global economy, central banks have stepped up to the plate by delivering significant amounts of easing. Official yields are now at or below zero for all developed economies, and asset purchases are surging.

Still, we see important differences between central banks. While the Federal Reserve Bank was able to cut rates by 150bps, the European Central Bank (ECB) and Bank of Japan (BoJ) kept rates unchanged at levels that were already sub-zero. All three central banks expanded their asset purchases, but while the Fed bought sovereign debt worth 7% of GDP in the space of six weeks, the ECB ‘only’ bought an equivalent of 1% of GDP.

We expect these differences in pace to be reduced. The Fed is scaling down purchases, while the ECB and BoJ will do more. Also, we expect controlled market conditions for German Bunds to become a blueprint for US rates. The People’s Bank of China (PBoC) has become more accommodative as well, and we expect a further reduction in rates to be part of their measured, targeted easing path.

With the strong reduction in rates over the past weeks, our scenarios for central bank easing are now fully priced in, except in China.

Since early March, the Fed has cut rates by 150bps, introduced at least a dozen support programs, bought USD 1.5trn in US Treasuries and MBS, opened FX swap lines, facilitated repos, eased leverage requirements and shown flexibility on credit rating criteria. In sum, the Fed has been forceful, flexible and creative in its response to the crisis.

The Fed will likely keep rates at zero for a long time. By ‘a long time’, we mean at least two years. Why? First, because they are not likely to meet their employment and inflation targets anytime soon. We think the consensus is still too optimistic on the trajectory of the bounce. Second, because Fed officials have repeatedly underlined their preference for forward guidance as a policy tool. And third, because low inflation expectations remain an important long-term concern. Being patient in raising rates should help in lifting these expectations.

Negative rates, however, are less likely. At his 15 March press conference, Fed chair Powell repeated that this is not their intention.

Although the measures announced at the early-March ECB meeting were significant, they were not considered sufficient in the eyes of European bond markets. President Lagarde’s remark that the ECB was not there to “close [bond] spreads” may not have helped in that regard. Hence, it took less than a week, during which spreads widened sharply, before the ECB was forced to step in and launch the new Pandemic Emergency Purchase Program (PEPP), with an overall envelope of EUR 750 billion. Simultaneously, it was decided to expand the range of eligible assets under the corporate sector purchase program (CSPP) to non-financial commercial paper.

The initial pace of PEPP purchases has been impressive and, probably due to the fact that purchases are conducted in a flexible manner skewed towards peripheral government debt, have managed to halt a further rise in European Government Bond spreads. Nevertheless, the pace still dwarfs that of the US Federal Reserve. Given the huge funding needs of Eurozone sovereigns – it seems likely that many countries will have budget deficits and hence net debt issuance of more than 10% of GDP in 2020 – it seems a matter of time before the PEPP envelope of EUR 750bn will be increased.

A lot has happened since our previous update on the PBoC, in early March. As we had expected, the central bank has indeed stepped up the pace of monetary easing.

This seems in part driven by the worsened external demand outlook in the wake of the economic lockdowns in Europe and the US. But the policy loosening also seems related to incoming evidence on the sheer scale of the Covid-19 shock, with Chinese real GDP having contracted by an unprecedented 6.8% year-on-year in Q1. Even though the viral outbreak in China has seemingly moved (further) in the right direction and industrial activity is gradually getting back to a more normal pace, the 17 April Politburo meeting signaled that there is still more macroeconomic policy loosening to come.

While initially reluctant to act in response to Covid-19, the BoJ finally enhanced their monetary easing bias forcefully – and we expect more to come. While the easing framework offers little surprise, we do take a positive view of the qualitative and quantitative easing designed to ensure smooth financing of financial institutions and corporates, amid the sharp economic downturn triggered by the Covid-19 crisis. For the Japanese economy, the timing of this shock could hardly be worse, as the economy was still struggling with the negative effects of the VAT hike at the end of last year.

With the BoJ now more actively supporting the government by additional buying of Japanese government bonds, and through more pronounced support of the private sector at the request of the government, we could be witnessing the first steps of monetary policy being made explicitly accommodative of fiscal policy – in other words, fiscal dominance.