It was supposed to be the year interest rate differentials between the U.S. and other developed nations grew, and rising U.S. interest rates were meant to put a floor under the strong dollar. Certainly everyone agreed at the beginning of 2017 that the U.S. Fed was going to continue on their path of increasing interest rates and they have not disappointed, raising rates at a measured, quarterly pace in both March and June.
What markets had not bargained for, however, was that other central banks around the world might also start to think about normalizing interest rates. It is early in the process, to be sure, but several central bank governors in the major economies have begun to hint that the era of ultra-low or below zero interest rates may be about to be curtailed. For now, low interest rates and quantitative easing (QE) are still flooding the world with excess liquidity, central bank balance sheets remain bloated and markets remain complacent, but times may be changing more quickly than expected.
The U.S. has always been on the vanguard of the developed economies when it comes to the extraordinary stimulus project. They were the first sovereign to inject capital into their banking system, among the first to get to the zero bound of interest rates, and the first to institute a large-scale QE program. Similarly, they have been the first central bank to begin to raise interest rates, and recently have become the first to address the issue of tapering the reinvestment of their bond purchases, thereby (very) slowly shrinking the size of their balance sheet.
Initially, just $10 billion of Treasury and mortgage-backed securities will be allowed to run-off monthly, although the pace will increase incrementally on a month-by-month basis. Despite a higher Fed Funds rate and the requirement for the market to fill the hole created by the gradual wind down of QE, market expectations for further interest rate increases are below the level indicated by the Federal Reserve’s own forecasts. This appears to be driven by near-term inflation numbers, which have been weaker than anticipated, as lower oil prices and limited wage increases (despite near full employment) weigh on both demand and supply.
Perhaps emboldened by the reaction to the U.S. bond market to floating the idea of balance sheet reduction – the reaction was zero – other central banks are testing the waters and gauging the reaction of bond markets.
In Europe, Mario Draghi attempted to explain the “evolving” monetary policy stance of the ECB, but markets only listened to his relatively upbeat views on the economy, its lower unemployment rate and the recently reduced political uncertainty. The result was a strong move higher in the euro to put it 4 percent above the ECB’s 2017 forecast and a near doubling of 10-year German government yields from 0.24 percent to 0.47 percent at the end of June.
In Canada, Governor Stephen Poloz of the Bank of Canada sent an even stronger message that they are considering raising interest rates from the record low level that was instituted in the wake of the collapse in oil prices in 2015. This was a significant departure from a statement made only a month ago that “uncertainties continue to cloud the global and Canadian outlooks.” Short-term interest rate markets instantly doubled the probability of a hike in Canada, the 10- year Canadian government bond rose by 0.29 percent, and the Canadian dollar rose substantially versus the USD. The Bank of Canada followed its rhetoric with an interest rate increase in early July in admission that Canada now has one the highest growth rates in the developed world (along with the hottest property market).
In the U.K., the Bank of England (BoE) split and voted only 5-3 to keep rates steady at its last meeting. Mark Carney, the Governor of the BoE, then signaled that U.K. base rates may have to rise in the coming months. His comments ran completely counter to his words of only a week prior, and as with the European and Canadian markets, long-term interest rates rose and Sterling strengthened. We tend to believe that the thoughts toward higher rates in the U.K. are too early. In the first instance, the BoE has started to increase cyclical capital requirements for domestic lenders, which should ease unsustainable growth in domestic lending, a key concern for the central bank. In addition, a number of key indicators in the economy appear to be rolling over. The data seem to be pointing toward a weakening economy at the same time as Brexit negotiations and an unstable coalition government are starting to weigh on sentiment.
For now, our baseline view is that any move toward less accommodative global monetary policy will be very gradual, but it is a dangerous time to invest in the bond markets, with very little cushion for error.
Andrew Baron, CFA is Chief Investment Officer, Butterfield Asset Management.
The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.