Central Banks as Market Participants

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1 Investment Insights Central Banks as Market Participants Central banks function to guide economies on a steady path and to create an environment that supports a higher standard of living over time. Prior to the credit crisis, central banks were best known for setting interest rate policy in response to changing economic conditions and for their focus on maintaining predictable levels of inflation. However, given the scale and scope of the global credit crisis, central banks have since featured much more prominently in markets through a number of largely unprecedented and extreme direct measures. These measures variably took aim at strengthening bank balance sheets, stimulating the flow of credit, reinvigorating investor risk appetite, and combating disinflation. While some of these actions are of a temporary nature, we expect others will prove to be enduring structural shifts in central bank policy. The persistently fragile state of the global economy suggests that central banks will remain prominent participants in financial markets over the medium term, and will continue to have a significant impact on how investors form expectations and make investment decisions. With these expectations in mind, this paper revisits the more extraordinary central bank policies of this period, evaluates the success of these policies to date, and considers the implications of central bank policy going forward for capital markets and investment strategy. Unprecedented Monetary Easing The Bank of Canada (BoC) estimates that the financial crisis reduced global economic output by a cumulative US$10 trillion between , representing approximately 15% of foregone global GDP. 1 Yet, it is widely believed that the global economy escaped an even deeper depression as a result of the coordinated and extraordinary action taken by the world s central banks. 1 The Legacy of the Financial Crisis: What We Know, and What We Don t, speech by Bank of Canada Governor Stephen Poloz, November 3, 2014.

2 As a first step in response to the financial crisis, central banks responded swiftly and in a coordinated fashion by reducing key interest rates (policy rates) to emergency levels, as illustrated in Figure 1 on the previous page. However, this soon proved inadequate, and they were forced to implement more drastic monetary easing measures in order to restore solvency and the flow of credit in the global financial system, reinvigorate demand for risk assets such as equities and credit instruments, and stimulate capital investment and employment in the private sector. To accomplish these objectives, central banks unleashed a number of unprecedented and extraordinary measures that we will summarize in the sections that follow. Quantitative and Credit Easing In its simplest form, quantitative easing (QE) involves central banks printing money to purchase government bonds. By expanding the monetary base and increasing the liquidity of bank balance sheets, QE strives to encourage financial institutions to increase lending toward productive economic activity. Furthermore, by reducing the available supply of government bonds, QE also aims to lower borrowing costs and increase the value of riskier assets such as equities, corporate bonds, and other credit instruments. Credit easing is a particular subset of quantitative easing that pursues an additional goal of restoring function in a specific asset market. The most prominent credit easing activity in the post-crisis era was the U.S. Federal Reserve s (the Fed) purchase of close to US$2.3 trillion of mortgage-backed securities and Federal Agency debt when those markets were badly listing. 2 This provided liquidity to the market and also improved lender balance sheets, freeing them up to offer additional and cheaper mortgages to the beleaguered housing market. Collectively, the quantitative and credit easing activity undertaken by the Fed was referred to as QE1, QE2, and QE3. The Government of Canada offered a hybrid credit easing program of its own (though funded by government borrowing rather than money printing) by purchasing $69 billion of insured mortgages, 3 while the Bank of England purchased corporate bonds as a means of lowering credit spreads and supporting the function of its corporate bond market. 2 The Rise and (Eventual) Fall in the Fed s Balance Sheet, Lowell R. Ricketts and Christopher J. Waller, The Federal Reserve Bank of St. Louis, January 2014; Bloomberg. 3 Canadian Housing Observer 2012, CMHC. Phillips, Hager & North Investment Management 2

3 Easing Lending Requirements In addition to purchasing large amounts of assets, central banks around the world eased their lending requirements, making it much easier for financial institutions to borrow from them. Typically, central banks require high-quality collateral, their loans tend to be very short term, and the parties with whom they transact are limited. To enhance the availability of liquidity following the financial crisis, central banks took the unorthodox approach of accepting lowerquality collateral, extending the duration of loans, and extending credit to a broader set of institutions. Negative Interest Rates Until recently, 0% was considered the absolute lower bound on policy rates due to fears that negative interest rates would cause distortions in the money market and insurance industries. A negative interest rate essentially imposes a cost on banks for keeping extra money in their account with the central bank, thereby encouraging them to increase lending activity. This lending, in turn, is meant to support productive investments and stimulate economic growth when banks might typically hoard cash provided by liquidity measures. Negative interest rates from central banks also encourage interbank lending, thereby promoting the effective functioning of the banking system. Now that several central banks, including the Bank of Japan (BoJ) and the European Central Bank (ECB), have lowered their rates into negative territory with surprisingly effective results, previous constraints no longer appear as binding as once thought. We are still in the early days of assessing the impact of negative interest rates, but in late 2015 many private banks made the decision to absorb the costs themselves rather than pass them along to consumers in countries where negative policy rates had been implemented. Transparency and Forward Guidance The intention of transparency is to enable market participants to better anticipate central bank actions and avoid disruptions caused by otherwise unexpected policy actions. Heightened transparency also lends credibility to a central bank s commitment to its policy objectives, thus affording more flexibility to deviate from its traditional tools in pursuit of those objectives. Finally, transparency can be used to manage expectations. The articulation of a central bank s expectations for future short-term interest rates and economic conditions is referred to as forward guidance, and it helps central banks influence long-term rates, which can guide decisions in the private sector. Phillips, Hager & North Investment Management 3

4 Although the BoC was an early adopter of forward guidance, Governor Poloz abandoned this strategy in 2014, but stressed that it could be used as an unconventional tool in the event that the central bank was operating at the effective lower bound of interest rates. 4 The Fed has been particularly active in increasing transparency in the post-crisis era, and other central banks including the ECB and BoJ have employed this strategy to some degree as well. We expect this trend from central banks will continue in an attempt to manage expectations as we emerge from this era of unusually accommodative monetary conditions. Evaluation of Monetary Policy Success The aggressive and unconventional monetary policy measures implemented in the wake of the financial crisis have achieved some very important successes; that said, progress across the objectives identified earlier in this paper has been varied, and there have also been some negative side effects. Indicators of Success As broad evidence of monetary policy success, one can point to the U.S., where the Fed was the earliest and most aggressive adopter of extraordinary monetary policy measures. Today, the U.S. economy is enjoying strong and broad-based economic growth, and the country s central bank is preparing to return to more normalized monetary conditions while other central banks continue to ease. Early actions by the Fed were critical to restoring solvency and the flow of credit across the financial system. Direct support to the mortgage market helped restore order to that market and to reinvigorate the domestic housing sector. By comparison, the ECB was slower and more limited in its implementation of aggressive measures, and in that region, economic growth remains muted, deflationary fears persist, and the flow of credit from banks into the real economy remains constrained. Certainly, lower policy rates and quantitative easing helped lower interest rates globally, and these lower rates in turn lowered borrowing costs and provided strong support to risk assets. Until recently, the investment grade and high yield corporate bond markets as well as the equity markets enjoyed very strong performance and low return volatility. Investor risk appetite remained healthy during an extended period of low government bond yields, contained inflation, and supportive monetary policy, and the wealth effect of higher asset prices restored consumer confidence coming out of the global recession, despite vexing slack in employment and wage growth. Central bank policy therefore made strong positive contributions to stemming a solvency crisis in the global financial system and putting mechanisms in place to help the global economy return to positive territory, albeit with relatively weaker and uneven growth. 4 Integrating Uncertainty and Monetary Policy-Making: A Practitioner s Perspective, Stephen Poloz, October Phillips, Hager & North Investment Management 4

5 Mixed Results and Negative Consequences Incentives created by monetary easing for financial institutions to extend credit into the real economy had less of an impact. Although the supply of bank credit remained strong throughout the credit crisis in Canada, this was not indicative of a broader trend, as Canadian banks largely avoided the financial crisis. In other developed economies, the flow of credit from financial institutions was very slow to emerge. Initially, banks contended with severely damaged balance sheets, and later, once central banks had bought government bonds and other distressed securities and bank balance sheets were significantly healthier, the cash simply sat in reserve accounts at the central banks, preventing large quantities of money from flowing through the economy. See Figure 4 for an example of this in the U.S. Constrained access to credit had a meaningfully negative impact on small- to medium-sized businesses, which are critically important to supporting employment and economic growth. Furthermore, despite strong access to low-cost borrowing through the corporate bond market, capital investment from large private sector employers remained disappointing as many corporations maintained very high cash reserves and/or focused on financial engineering in order to generate shareholder returns. These activities increased leverage in the private sector and diluted the potency of the unprecedented measures instituted by central banks. Limitations of Monetary Policy Although the actions of central banks since the credit crisis have provided a backdrop to facilitate a return to positive growth in developed economies, they have not managed to achieve sustained levels of growth that would enable a return to more neutral monetary conditions. We argue that this is not a failure on the central banks behalf, but rather an indication of the limitations of monetary policy. Central bank actions have certainly enabled and stimulated credit growth, but this credit growth has not been coupled with sufficient capital investment or employment and wage growth to achieve the rates of broad economic growth that typically accompany an economic recovery. This is the result of a number of factors, including aging demographics and large debt burdens across the developed world, declining productivity gains and the need for economic reforms in emerging markets, and elevated levels of geopolitical instability that impact negatively on Phillips, Hager & North Investment Management 5

6 investment activity. Monetary policy alone cannot address these challenges at this stage, its most significant benefits in achieving a robust economic renaissance may have been realized, and future economic progress likely relies more on productivity enhancements achieved through effective government policy and investment growth in the real economy. Looking Ahead Notwithstanding the recent hike to the Fed s policy rate and its intentions to continue increasing this rate gradually over the next several years if supported by economic conditions, global monetary conditions will likely remain accommodative over the medium term. Facing subpar economic growth and ongoing deflationary threats, central banks in Europe and Japan remain steadfast in their commitment to take whatever actions necessary to achieve their policy objectives. The ECB, for example, extended its quantitative easing program in late 2015, and the BoJ recently lowered its policy rate into negative territory and unveiled unexpected plans to purchase shares of exchange-traded funds that mimic its benchmark equity index. In December 2015, the BoC confirmed that among other unconventional tools, it would consider moving to negative policy rates if economic conditions continue to deteriorate. In this environment, we expect interest rates will remain range-bound at historically low levels in the near term, and that when policy rates do begin to rise, they will settle at lower levels than in previous economic cycles. In the coming years, financial markets will likely be shaped by the combination of persistently low global interest rates, heightened attention on the future path of interest rate hikes by the Fed, and the unprecedented nature and complexities of the eventual unwinding of monetary policy. Specifically, we anticipate the following developments in the coming years: All Eyes on the Fed. We expect market participants, central banks, and governments alike to remain fixated on the Fed as it begins to normalize its monetary policy. The actions of the central bank bellwether will establish a precedent for other central banks, but until those central banks likewise begin to raise their rates, this will result in continued divergence in monetary policy across the globe. This could sustain or even exacerbate market volatility as financial markets grapple with uneven global growth. Interest Rate Sensitivity. Higher debt loads in both the private and public sectors will make future economic growth much more interest rate sensitive, meaning that a return to more neutral monetary conditions including higher policy rates will prove challenging. Recent financial market volatility, partly in response to the Fed communicating and beginning to implement a cycle of monetary tightening, offers evidence of concerns over the sustainability of global growth in a world of higher interest rates. Greater Vulnerability to Future Downturns. With fewer tools remaining at policymakers disposal, central banks may become less able or willing to stem risks and volatility in capital markets. We expect this dynamic to contribute to ongoing volatility and declining liquidity Phillips, Hager & North Investment Management 6

7 conditions in capital markets. This could result in greater vulnerability to future downturns, and/or deeper and more frequent recessions. Integration of Financial Stability. We expect central banks to continue integrating financial stability into monetary policy objectives and considerations, and to have an increasing role in regulatory oversight. Although central banks around the world are at different stages of integrating financial stability and monetary policy, all major central banks and policymakers recognize that one cannot operate without consideration of the other. A Complex Road to Recovery. Some of the more unconventional measures adopted by central banks are imprecise in their impacts on the economy and markets. Eventually, monetary policy authorities will have to address the size of their balance sheets, and when they do, the complexity of the unwind will heighten the potential for policy errors. Implications for Institutional Investors The pressure on institutional investors to sustain portfolio returns is immense; however, given the heightened risk of widely divergent outcomes for the global economy and capital markets, this is a challenging period of the business cycle during which to push the boundaries of policy risk budgets. The overarching implication for institutional investors over the medium term, we believe, is that a balanced and prudent investment policy is more important than ever. In the context of this environment, we highlight certain elements of investment policy for consideration below: Duration Policy. Government bond yields have hovered at very low levels for several years, and as a result, many investors looking to de-risk have chosen to temporarily depart from, or delay moving to, their fixed income policy duration targets. In some cases, these tactical decisions have hurt fixed income portfolio returns, and certain defined benefit pension plans that opted to defer their de-risking plans have seen deterioration in funded status as interest rates continued to decline. We have long maintained that attempting to forecast interest rates is an unreliable strategy for augmenting fixed income returns, and our view has not changed despite the current level of bond yields suggesting rather pessimistic long-term prospects for the Canadian economy. Moreover, empirical evidence from outside of Canada suggests that we cannot discount the possibility that bond yields could go lower still, particularly given that the BoC recently discussed the potential use of negative policy rates. Against this backdrop, we believe that investors making tactical duration decisions would be well served by considering the high degree of uncertainty associated with the direction of interest rates over the medium term. Investment Return Objectives and Asset Mix Policy. Since the financial crisis, many institutional investors have considered and/or implemented material structural changes to their asset mix policies in an effort to maintain growth expectations. Global and high yield sectors of the bond market have become more common features in institutional portfolios, Phillips, Hager & North Investment Management 7

8 and equity interest in a broader range of global assets including infrastructure, real estate, and private equity has grown. Many investors have funded these new investments at least in part by reducing domestic fixed income allocations, thereby possibly reducing the liquidity, liability hedging, and stability profiles of their investment portfolios. Alternatively, some investors have responded to the current environment by lowering their forward-looking return expectations. Depending on a portfolio s objectives, we believe both approaches have merit but that pursuing ever more aggressive asset mix policies is best done with an eye to risk tolerance, current global economic challenges, and the relatively unprecedented nature of the current monetary environment. Given that central bank policy has been maintained at such accommodative levels throughout this economic cycle, this may be suggestive of a protracted period of relatively weaker economic growth, lower capital market returns, and increased uncertainty in the cash flow generation capability of real and financial assets going forward. Manager Structures and Guidelines. Many institutional investors implement their policy asset mix through specialty structures in which individual managers are confined to investing in a single asset class. In some cases this structure is further refined; for example, by bifurcating fixed income structures into sub-asset classes such as government bonds, investment grade corporate bonds, global bonds, and high yield bonds. This specialty approach has intuitive appeal because it provides investors with increasingly granular control over their asset allocations. However, this approach limits the ability of investment managers to make tactical adjustments to the portfolio to protect it from evolving risk conditions in markets, and to capitalize on increasing performance dispersion across asset classes and geographies. In the future, investors might stand to benefit from partnering with a selection of their managers to adjust portfolio positioning tactically as market expectations for monetary policy evolve, particularly as divergence in monetary policy increases as central banks become increasingly focused on responding to domestic economic conditions. Ultimately, we believe that investors should remain focused on their objectives and fight the temptation to time market developments. We suspect there are several developments that have yet to be seen, and in such an environment a multiple-strategy approach is a prudent way to diversify portfolio risks. In addition, as corporations that have borrowed heavily in an era of historically low interest rates manage the impact of rising rates, the ability of investment managers to navigate a constantly changing market and perform thorough credit analysis will remain critical to mitigate unintended risks. We see the benefits of active management in an uncertain environment as a necessary tool to manage and control risk within all asset classes. For additional details, please contact your PH&N IM institutional portfolio manager, or call or institutions@phn.com Phillips, Hager & North Investment Management 8

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