I have a strong feeling that we’ve been here before. Major central banks making tightening noises with nothing to little happening has been a recurring theme since we started this blog. So what could be different this time? Three of the four major central banks have effectively billed the next quarter as one where they will or could tighten policy. But, what about inflation? Are central banks ripping up the rulebook, mistrusting the data – or at least adjusting their lens? And the latest news from loan markets can’t help but make you wonder how far this debt cycle has to run.
Winds of change?
For almost a decade now major central banks have been fighting low inflation and above-target unemployment on two related fronts: virtually zero interest rates and quantative easing. We’ve had a few false tapering dawns followed by a few isolated moves from the Fed, but the loose monetary narrative has remained pretty constant. It’s not surprising that investors have become a little accustomed to this low interest rate world.
Perhaps they’re waking up now. On Wednesday, the fixed income market experienced its worst day in two months followed by a significant sell off in government bonds on Thursday. And, whilst it’s impossible to ever attribute single reasons to market movements, this fits within a broader rise in yields and shifting central bank narratives, with the Financial Times terming this: ‘The QE retreat’ (FT subscription).
This one vital element is different: three of the four major central banks have tightening on the agenda. The Bank of Japan is the only exception. Next week brings the start of October, the month when the US Federal Reserve’s begins paring back its $4.5t balance sheet – a big milestone. The ECB is due later in the month to discuss shrinking its own balance sheet. More speculatively, the Fed appears to have a rate rise pencilled in for December and the odds on a UK rate rise before the end of 2017 are now above 80%, from around 20% just a few months ago.
One of the other main reasons why global tightening is on the agenda is the almost universal uptick in global growth, underpinned by a pickup in trade. Previously, at least one major region was acting as a drag – mostly the Eurozone, which is now growing faster than the US. Nevertheless, the picture isn’t straightforward and neither is any bank’s position on the data. The US and the Eurozone are growing more strongly, but inflation remains below target in both regions. In the US, unemployment is low and at a level that might have raised questions about slack in the economy in the past, but not without a concurrent rise in inflation. The Eurozone jobs picture is just “improving” for now. In the UK, the fallout from Brexit confuses the picture, but the Bank of England is arguing that slack in the UK economy is diminishing, reducing the UK’s tolerance of above-target inflation.
It’s the nature of modern central banking that any moves are flagged a long way ahead. Therefore, whilst nothing is certain; we can say that the Fed and Bank of England at least look strongly minded to act unless their economy’s deviate. Still, this all raises an interesting question: rates could be rising when inflation says ‘no’ – or at least ‘maybe wait a while’ – so how can we second-guess what central banks will do next?
Never mind the inflation, feel the risk?
Just to add to the challenge and confusion, the Bank of International Settlements – the central banks’ central bank – is just one agency questioning if if age-old economic models are still working. We just don’t know how much globalisation and digitalisation are affecting inflation. Is it moving beyond local monetary policy? It’s a radical thought, but for evidence of this in action, we only need to look at the pricing transparency and push-back on pricing power in retail and hotel bookings. And could there be other reasons for banks to start tightening. The BIS are also concerned about the extraordinary build-up of debt – and concurrent drop in lending conditions – something that could makes monetary tightening both necessary and dangerous at the same time.
We don’t have to look too far for examples of potential hubris. A report from Moody’s in the summer said that cov-lite was “fast becoming the new normal in Europe”. This week, an article from Lisa Abramowicz on Bloomberg argued that junk-rated loans and bonds are looking more and more alike. New issues of US leverage loans have overtaken issues of high-yield bond this year.
In the past, loans were thought to be safer than bonds because they were governed by tighter protections and were repaid first in a bankruptcy. As a result, they offered lenders lower interest rates than comparably rated bonds. But those lender protections are steadily being stripped away. By some estimates, 85 percent of loan deals for bigger companies backed by big private equity firms are now considered covenant-lite, or lacking provisions allowing investors to step in when a borrower tries to incur much more debt.
This isn’t universal. In Asia, loan lending has crashed. There is some talk of greater push back on terms in recent weeks – at least in Europe – but this is still around the margins. The value of global private equity transactions has risen to $212bn, in the year-to-date, the highest in ten years. PE is looking at bigger and bolder deals, helped by bountiful dry power as well as helpful debt markets. High liquidity has some benefits. European markets can absorb larger loan issues from mega-deals without stalling – as they have in the past. It adds to the feeling that we’re perhaps or approaching the peak of the cycle, but again we’ve been here before.
Tough to say on all counts. This is such a complex picture for all the reasons discussed above. Central banks could be signalling interest rises in part to ward off complacency, although investors are less likely to take notice the next time if they’ve cried wolf . They also have macro-prudential means at their disposal, including tighter terms on consumer loans and leverage ratios to manage the credit cycle. Further action here cannot be ruled out.
Which brings us to now almost compulsory ‘uncertainty’ section. Global growth is looking as good as it has in some time; but global risks – conflict, protectionism – are also as high as they have been in some time. There are lingering concerns about the data veracity, which will create further uncertainty. Janet Yellen’s recent speech suggests that she thinks that the disparity between employment and inflation is probably due to temporary factors; if this doesn’t play out – or there are more temporary factors, the next US rate rise might be the last for a while. The ECB is likely to move very slowly in whatever it does. The Bank of England, whilst seeming to prepare the ground for a move in November, according to EY ITEM Club is likely to:
“tread very carefully on further increases” and “may well sit tight for an extended period after an initial hike to see how consumers and businesses respond.”
It too is concerned about the veracity of available data.
In about a month we’ll be releasing the result of our latest Capital Confidence Barometer and it will be fascinating to see companies’ views on funding in this changing environment.