Among the topical theses we explore in our working strategy sessions, the most mind-boggling, without a doubt, for most observers would be the strange phenomenon of negative interest rates. Lately it has spread as if it were a global epidemic, though it has not yet arrived in Canada.
Why negative rates?
What is the story behind negative interest rate policy (NIRP)? It remains the era of the central bank, we believe. While many investors rightly recognized unsustainable global imbalances and the reality of slow economic growth, they also respected the “central bank put” (meaning downside protection). As such, in recent years, the reputations of central bankers have come close to deity-like status. But how long can this reverence for the world’s monetary priests last? And is the new monetary toolkit of policies a work of divine brilliance or are they “making it up as they go along”? Nothing lasts forever (including the infallibility of central banks) and, yes, desperation is proving to be the mother of invention as far as introductions of unorthodox policies are concerned.
Recently, there is growing sentiment that the “Quantitative Easing (QE) bubble” has come to an end and that NIRP is ineffective. To many, QE is viewed as benefitting only the wealthy (i.e., capital owners who profit from rising asset prices). NIRP is also widely viewed as highly problematic, particularly for the banking sector. Recent under-performance of European and Japanese banks reflects this concern. Banks are reluctant to pass on negative interest rates to their retail customers. A negative charge on deposits acts as an effective tax on the banking sector, squeezing their net interest margins.
PQE beyond NIRP
But what about moving beyond QE and NIRP? Could the world’s central banks attempt even more radical policies? These are the types of questions we now often hear from clients. This leads us to “People’s QE” (PQE) – a catchy phrase originating from the U.K., where a number of respected academics and the new Labour leader Jeremy Corbyn are pushing the idea. The basic argument is that central banks should provide money to the public with no expectation that those funds will be repaid: in other words, a permanent, money-financed fiscal expansion.
PQE could take several forms. The simplest would be for central banks to deposit cash directly into household bank accounts. This would be similar to a tax cut, except that there is no deterioration in the government’s fiscal position (no new debt) because the operation would be funded by the creation of new money. Alternatively, the central bank could directly fund infrastructure and public works spending. For example, the government could use money provided freely by the central bank to invest in highways, bridges, etc. It would fund itself by selling bonds (which never have to be repaid).
The growing supporters of PQE claim it would be more effective than QE because money would be immediately directed into the real economy. In contrast, existing QE works only through indirect channels, by raising asset prices and lowering interest rates. People’s QE could be less dangerous for financial stability because it would not over-inflate asset-price bubbles. PQE could even fight inequality as it boosts income growth, whereas QE mainly helps the wealthy who tend to hold financial assets. Given the right platform for PQE, the public would likely enthusiastically embrace the concept.
Central banks have become the lead sponsors of rising asset prices, effectively becoming victims of their own success. Attempts to cushion financial volatility always end up creating instabilities in the future. Yet, seven years after the financial crisis, not much has been achieved in terms of boosting economic growth. The central issue is that policymakers have not yet resolved the deficiency of world demand. That means we may have only scratched the surface in terms of possible unorthodox policy.
The next stage will likely see central bankers endorsing People’s QE: direct consumer cheques, higher budget deficits to sponsor infrastructure projects, central-bank funded tax cuts, etc. Economists in favour of these policies are often just fiscal stimulus advocates (perhaps hoping to use the central bank to stealthily push through quasi-fiscal measures).
Volatility to continue
To be sure, money-financed fiscal expansions carry a stigma, often associated with the Weimar hyperinflation of the early 1920s. However, PQE is gaining support. Indeed, it may yet be a few years before full-fledged PQE-type policies are actually put in place. However, as already witnessed, financial markets stand to remain very volatile throughout the transition period
Until last December, it had been more than 10 years since both the Star Warsfranchise’s last major installment and a lift in interest rates by the U.S. Federal Reserve. Both streaks were broken in December 2015. There arises one additional factor that has added gyrations to financial markets: the recent policy differences of the world’s major central banks. While the Bank of Japan and the European Central Bank have put in place deeply negative interest rates, in America the direction has been very different.
Trend to policy convergence
Markets remain obsessed with trying to guess the precise timing of further interest rate increases in the U.S. Rather than speculating about the Fed’s timing, it is far more useful to ponder the implications of a worldwide policy convergence. This is likely as policymakers realize that competitive policy wars have not raised global economic growth.
In a much-celebrated quote on his 50th birthday, the late David Bowie boldly declared to an audience at Madison Square Garden, “...I don’t know where I’m going from here, but I promise it won’t be boring.” Recent and expected financial markets carry echoes of those immortal words. In the opening months of 2016, action has been anything but boring. Investors cannot be faulted for feeling disoriented. To be sure, financial markets have and are reacting to legitimate macro fears.
Where to from here? It is useful to revisit the role of the portfolio manager. They certainly do not have powers of clairvoyance. Rather, it is to anticipate probable risks, prepare for opportunities and, importantly, not to lose our proverbial “heads” when everyone else has lost theirs in times of emotional upheaval. Expressly, that requires a disciplined approach that can extract emotion from the process.
Courtesy Fundata Canada Inc. © 2016. Tyler Mordy, CFA, is President and Co-CIO of Forstrong Global Asset Management Inc. Securities mentioned are not guaranteed and carry risk of loss. This article is not intended as personalized investment advice.
