The expectation for significantly looser monetary policy remains, with most major central banks guiding for rate cuts and potential expansion of quantitative easing. This has been led by the US, although followed rapidly by the European Central Bank as the economic data in the Eurozone deteriorated. The market anticipates an aggressive series of rate cuts from the Federal Reserve, in addition to the 0.25% cuts that has already been completed in July and September. Currently, investors are anticipating that one additional 0.25% cuts will take place this year, taking the interest rate to 1.5-1.75%.
The change in the US yield curve reflects the lowering of interest rate expectations, once again. As previously discussed, the inversion of the US yield curve is a closely watched technical indicator. Longer-dated bonds yielding less that short-dated ones are a signal that there is an upcoming recession as the market believes that rate cuts will be required in the medium term, as supported by the short-term interest rate expectations.
In the UK, the next move could potentially be in either direction, as guided by the Bank of England. There are sufficient pressures in the economy to justify an increase to interest rates, however, the threat of a no-deal Brexit continues to concern policy makers and as such, they are waiting to see the outcome before making their next move. It is assumed that a disruptive no-deal Brexit would lead the BOE to lower interest rates and potentially restart QE, similar to that done in 2016 following the vote to leave.
In Europe, the ECB is expected to keep monetary policy very loose, with increasingly negative rates and resurrection of quantitative easing. Importantly, the change in objective from a “at or slightly below 2%” inflation target to a simpler “2%”, removes the implied asymmetry and increases the willingness to tolerate slightly higher inflation. On balance this is likely to lead to looser monetary policy. There are still question marks over how negative rates can realistically go before they cause bigger issues, although we are now into uncharted territory, so it is difficult to draw any solid conclusions.
In September, the ECB announced that it was cutting rates to -0.6% from -0.5% and restarting its QE programme, with €20bn of monthly purchases starting in November. This was largely as expected but takes the single currency further into uncharted territory. The effectiveness of such action is still debatable.
It is worth noting that Government bond yields in the Eurozone have now reached historically low levels, with much of the universe with negative yields. Leading this is the German government bond market. The prospect of additional QE makes the attractiveness of the few remaining Bunds very high, even if they have a negative yield to maturity. Combine this with expected cuts to interest rates deeper into negative territory and there are valid reasons for some market participants to continue buying these securities.
As suggested previously, the next move by the Bank of England could go either way and will be entirely dependent on the outcome of Brexit. A “hard-Brexit” is likely to result in a cut in interest rates and potentially an expansion in QE. A more stable transition may lead to higher rates in the medium term as pressures built up in the system over the last several years warrant some reaction from the BOE. Currently, with the change to no-deal Brexit assumed probabilities the market is pricing in lower rates in the near term.
The Bank of Japan has continued with its programme of easy monetary policy; however, the rate of purchases has been slowing over the last several years. The last quarter has seen little change in the overall size of the Bank’s balance sheet. Nevertheless, it is increasingly likely that along with other major central banks, the BOJ will opt for another round of stimulus to try and stimulate growth in the near future.