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Mixed messages from central banks may be covertly signaling an end to quantitative easing, says Robeco’s Lukas Daalder.
Over the past years, central banks have successfully avoided unsettling markets over policy announcements by giving a steer that is neither too dramatic nor too vague. However, recent policy flip-flops suggest that central banks are now ‘nudging’ markets to start factoring in the end of monetary easing in Europe, says Daalder, Chief Investment Officer of Robeco Investment Solutions.
He cites a famous quote from former US Federal Reserve chairman Alan Greenspan, who said: “Since becoming a central banker, I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.”
“This makes it clear that communication by central banks is not always easy,” says Daalder. “When you are ‘unduly clear’ as Greenspan put it, past remarks can come back to haunt you if – for example – the economy takes an unexpected turn. Stay too vague on the other hand, and markets can become confused about what to expect. The best outcome, therefore, is taking the middle ground: keep your options open, never be unduly clear, and try to nudge the markets in the right direction.”
“This strategy has been successfully adopted: monetary policy announcement days have become boring events. The fact that the Fed has managed to administer three rate hikes in this tightening cycle and announced the first steps of QE tightening without upsetting either bonds or equities too much is clear proof that something has gone right in terms of communication.”
“With that observation in mind, it is puzzling to see what has happened over the past couple of weeks on this side of the pond: what is it that European central bankers have been trying to tell us? Increasingly it points to the end of quantitative easing.”
Daalder says a good example of how the new nudging may indicate squeezing can be seen by the usually sedate Bank of England (BoE). On 15 June, BoE Chief Economist Andrew Haldane was one of five members of the Monetary Policy Committee voting to keep rates on hold at 0.25%. However, within a week he made a U-turn, indicating that withdrawing some stimulus would be prudent. BoE Governor Mark Carney – who had also backed holding rates – echoed the same message on 28 June.
“So why the sudden change of heart?” asks Daalder. “In itself, there is nothing out of the ordinary or wrong with central bankers changing their views. Following the unexpected Brexit referendum outcome back in 2016, the BoE administrated extra monetary stimulus measures to soften the blow that was expected to hit the UK economy. The blow never landed, and the economy continued to expand, so that in itself could be a valid reason to take away some of that extra stimulus.”
It is difficult to see why the BoE should now change its position
“Nevertheless, it is difficult to see why the BoE should now change its position, given the weaker growth outlook, the fact that consumers are being squeezed with higher prices but a fall in real incomes, and BoE’s track record of taking a pretty relaxed stance towards ‘temporary’ inflation spikes. So, if the BoE is now serious about this, and if it wants to prepare the market for an upcoming rate hike, more nudging (and better economic data) should therefore be expected in the month ahead.”
Enter the European Central Bank (ECB), with a rather different scenario but the same type of contrarian nudging emanating from its President Mario Draghi. “The ECB has also been sending out mixed signals of late,” Daalder says.
“At the June meeting, Draghi surprised the market by lowering the 2018 inflation outlook to 1.3%, indicating that no real inflationary pressures were being built up, as tighter labor markets have not resulted in higher wage increases. Even for 2019, the ECB only forecasts inflation to reach 1.6% on average, which technically is even below its own target. The underlying message is: we are in no hurry to change anything to the current policy mix.”
We are not heading for anything radical, but rather, more nudging
“Then came a speech that Draghi gave on 28 June, where his remark that ‘deflationary forces have been replaced by reflationary ones’ came as a shock to the market, sending both the euro and government bond yields higher. Was this a case of Draghi being ‘unduly clear’, with the ECB trying to convince the market that it had misunderstood it?”
“So where does this leave us? Despite the somewhat confusing storyline, the underlying takeaway is that we are getting closer to the end of QE in Europe. Interestingly, the central bank that is the most verbal in that direction (the BoE) is the least credible, while the one that has been downplaying the prospects (the ECB) has a much better case to make. We are not heading for anything radical, but rather that we will see more nudging taking place in the months ahead.”
Daalder says the net impact on the financial markets should be that European bond yields will continue to weaken, with bond yields meandering higher. “We continue to be underweight government bonds, so we are not that displeased with the recent move,” Daalder says.
“Stocks have been helped by the low-yield, low-spread environment, while the prospects of central banks scaling back can act as a drag on sentiment. As we do not expect any sudden or quick policy changes, we currently stick to our neutral weight in equities. The only changes we have made to our portfolios have been on the currency front, as our short position in the UK pound has been stopped out.”