TwentyFour’s annual conference went virtual for the first time on Wednesday, and while we certainly missed catching up with our clients and peers in person, the online format of ‘Fixed Income Festival 2020’ proved no less effective in provoking debate on some of the key issues facing bond investors today.
Chief among these is the prolonged period of income scarcity we have likely entered as a result of central banks’ overwhelming response to the COVID-19 pandemic.
As I noted in my keynote speech on Wednesday, the last time US interest rates were slashed to near-zero in December 2008 it took a full seven years for the Fed to put through its first hike. The Bank of England and European Central Bank, meanwhile, had barely got around to thinking about raising rates from their post-crisis lows before COVID-19 forced them into cutting again.
The point here is that we are at the beginning of a very long cycle. If anyone was in any doubt about that, the Fed’s latest ‘dot plots’ released on Wednesday signalled that 13 out of the 17 members of the FOMC do not expect rates to rise again until 2024.
But could central banks go even further?
During my keynote we polled attendees on a simple if slightly provocative question: In the next 12 months, which central bank will cut rates again?
A cut by the Fed or the BoE from here would mean negative rates, while the ECB already has its deposit rate deeply negative at -0.5%. A 12-month horizon is of course plagued by what-ifs, but it is a good question for any market participant as it tests their fundamental view on what central banks can do, and what central banks should do.
The results of our poll were as follows:
The ECB – 11%
The Fed – 14%
The BoE – 36%
None of the above – 39%
I was not surprised to see ‘none of the above’ come out on top here (that would be my answer for the next 12 months), nor was I surprised to see the BoE a close second, but in my view the BoE shouldn’t be cutting and the ECB could actually be the surprise.
My view is that below zero the transmission mechanism breaks, so the pain of negative rates is passed onto the banking system but the benefits do not feed through to the broader economy. Banks are forced to pay negative rates to their central bank but are unwilling to pass them on to depositors as they understandably fear mass withdrawals. That effectively makes negative rates a tax on profitability and therefore capital generation, which means banks have less capacity to lend.
If the transmission mechanism did work properly then zero would be just a number; rates could be cut well below that level and have the desired impact on lending (imagine mortgage rates at -2%). It will be interesting to see if either the BoE or the Fed can find a way of mitigating some of the negative consequences of sub-zero rates, but in the absence of effective transmission, the policy makes little sense to me given the other tools available to central banks. The BoE has said this, as has the Fed, but I believe both are showing too much respect to the ECB by not being more critical of negative rates. The ECB has been using them for six years now, and has given a perfect demonstration of why they don’t work in their current structure.
Back to other policy tools, and this is the real reason why we think rates won’t go negative in the UK or the US. Negative yields have an immediate impact on government bonds, but government bond yields are already where the central banks would like them to be. Most businesses and consumers however do not borrow at these rates, and it’s this credit spread that the central banks are concerned with. The question is, can they lower the rate these borrowers actually pay, and how broad and how low can they make it?
One easy solution would be more or wider corporate QE. Another would be more targeted lending operations (such as the ECB’s TLTROs) where banks are given very cheap financing for specific types of lending. In Europe this tool has been quite effective, even with negative rates, as the ECB is effectively running a dual interest rate policy with a new, lower rate for the TLTROs, which is a proper incentive for the banks to take them up and lend on at lower rates.
The COVID-19 pandemic did provoke policy innovation, with governments and central banks teaming up to support some very specific and targeted forms of lending. The one common thread though is the attempt to bring interest rates lower for as many borrowers as possible, effectively targeting the credit spread, which has widened due to the economic backdrop. In my view, these are far more useful tools than taking base rates into negative territory.
So what about the ECB? We know the ECB was one of the few central banks around the world not to cut rates in response to the pandemic, perhaps sending the message that -50bp was as low as it would go. We certainly thought that at the time, but with the playing field of short term rates levelled by other central banks’ cuts, around the world the negative carry attached to owning euros has been markedly reduced, and it is principally this that has given the ECB a disinflationary headache in the form of a stronger currency.
So while Christine Lagarde and her committee are scratching their heads on how to fulfil their mandate of close to 2% inflation while fighting an uphill battle against a structurally stronger euro, they might just conclude that the simplest option would be to reopen the door to lower rates and cut the deposit rate by another 10bp, in the mix with other fresh stimulus.
I still think ‘none’ is the correct answer for the next 12 months, but if I had to pick one, it might just be the ECB.