Central bank watcher: Fiscal financiers

Central bank watcher: Fiscal financiers

18-06-2020 | Insight

As economies reopen after the pandemic-induced lockdowns, the collateral damage to public finances is becoming evident. Against this backdrop, central banks keep providing unprecedented amounts of funding for sovereigns.

  • Rikkert  Scholten
    Portfolio Manager
  • Bob Stoutjesdijk

Speed read

  • Fed may be formalizing yield curve control
  • It’s still all about PEPP at the ECB
  • The People’s Bank of China is not done yet

The collateral damage to public finances is becoming evident as economies reopen after the pandemic-induced lockdowns. In this setting, central banks have been providing unprecedented amounts of funding for sovereigns. They are also providing, or are about to provide, large amounts of financing to the real economy. This is either directly – via direct lending programs or private sector asset purchases – or through banks. In short, central banks truly have become ‘lenders of first resort’.

The ‘anything goes’ policy approach suggests that any relapse in the resumption of economic activity, for example due to a second wave of infections, will likely be met by more liquidity pumping or asset purchases. It might also lead to renewed talk of more deeply negative rates in the Eurozone and Japan, and the adoption of negative interest rate policy in the US. For now, this is not part of our base case. Our scenarios for policy rates still see the biggest scope for rate cuts in China.

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Source: Bloomberg, Robeco, change 12m ahead, based on money market futures and forwards

Federal Reserve: formalizing yield curve control

The trajectory of the virus and speed of re-opening of the US economy will be important drivers of US rates in the coming months. The development of the virus is a big unknown, and the path back to pre-virus levels of employment and inflation will be a long one in our opinion. The latter matters for the rates outlook. While positive news on the recovery momentum will influence risk sentiment and rates shorter term, any material move in bond market conditions will be driven by Fed policy. The Fed has been pretty clear on their stance. In the words of Vice Chair Clarida, on 16 June: “The Federal Reserve will continue to act forcefully, proactively, and aggressively…to provide critical support to the economy during this challenging time”. The market prices in a zero fed funds rate for some time to come, with even a small negative tilt. We see little reason to disagree.

ECB: PEPP keeps doing the heavy lifting

At its early-June policy meeting, the ECB increased the overall PEPP envelope by EUR 600bn, to EUR 1.35trn, and extended it to at least the middle of 2021. Moreover, it announced that principal payments from maturing securities purchased under PEPP would be fully reinvested “until at least the end of 2022”. Opting for a EUR 600bn increase in the size of PEPP by “broad consensus” versus market expectations for a top-up of c. EUR 500bn, suggests that the majority of the Governing Council was keen not to disappoint. As Chief Economist Lane explained the following day, two factors called for further, decisive action. First, the pandemic-related downward revision to the inflation outlook, with ECB staff forecasting Eurozone core inflation to reach only 0.9% in 2022. And, second, the still-fragile financial market conditions. Here, action was needed to ensure “smooth policy transmission” and support lower funding conditions for the real economy in all member states, given the tight links between sovereign and private-sector borrowing conditions.

People’s Bank of China: not done yet

It’s been relatively quiet on the rate cutting front in China of late. Instead, the focus has been on fiscal policy, specifically the supply of (special) government bonds, as well as on the signs of further economic recovery. Talk of further rate cuts has also been dampened by the announced targeted credit easing on 1 June, comprising RMB 40bn in relending to local banks and a RMB 400bn quota to buy 40% of uncollateralized SME loans from qualified lenders. To us, the latter initiative reads as the Chinese equivalent of a 1-year ECB TLTRO.

Since we see a possibility of a derailed economic recovery in China – related to the risk of a second wave of infections either in China itself or abroad – the risks around our baseline still seem to be skewed to more monetary easing.

Challenges for the Bank of Japan

We think that the BoJ will face more challenges even as the Covid-19 situation subsides, as it seems very ambitious to expect 2% inflation in the foreseeable future. Further easing by cutting policy rates probably has a very limited and perhaps even a negative impact on the economy and inflation, because both short-term and long-term policy rates are already close to the effective lower bound, especially considering the severe impact on the financial system. The impact on the currency is probably also limited, as yields of major economies are already close to zero in real and nominal terms. We are very skeptical that Prime Minister Abe’s government will pursue the 2% inflation target by using fiscal policy, given Japanese voters’ aversion to inflation.

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