Commentary by the European Central Bank (ECB) and Bank of Japan (BoJ) over the past month has challenged expectations about the longevity of their quantitative easing (QE) and negative interest rate policies. This, combined with guidance from the US Federal Reserve that economic conditions may warrant an increase in the federal funds rate, has put bonds and income equities under pressure. These markets have been further negatively impacted by the oil price recovery and by media reports that the ECB may be contemplating slowing its QE programme. The latter was quickly denied.

A negative side effects of extraordinary monetary policy

The discussion on the effectiveness of extraordinary global monetary policy has increasingly focussed on the potential negative impact on the banking industry. Banks are already facing more complicated regulation, and in many cases ongoing non-performing loans. The ECB and BoJ will be mindful that the efficient transmission of central bank monetary policy requires a healthy banking system. Banks have enjoyed the initial phase of extraordinary monetary policy which lowered funding costs, concurrent with inflating asset prices, but longer term they can feel the pinch. Central bank asset purchases squeeze the difference between short and long dated interest rates (removing the yield curve term premium). This reduces the profitability of banks that borrow short and lend long.  Meanwhile negative interest rates squeeze bank net interest margins as banks are reticent to give customers a negative rate on deposits. These combined challenges have reduced bank profitability in Europe and Japan.

The topic has received increased press coverage due to public statements by the IMF and many bank CEOs. However, comments from the head of the ECB and BoJ have been most notable:

  • ECB president Mario Draghi commented at the recent IMF meeting that a prolonged period of low interest rates has ” side-effects for banks, insurance companies, savers and it might also have effects on financial stability”.
  • BoJ governor Haruhiko Kuroda outlined in a speech to the Brookings Institute that “based on the experience in Europe and Japan, it is becoming increasingly evident that an excessively lowered and flattened yield curve could weaken the transmission mechanism of monetary easing by squeezing banks’ profit. In addition, a decline in expected rates of returns of insurance and pension products may have an adverse impact on consumers’ confidence”.

There have been numerous developments this year illustrating potentially increased empathy from regulators towards the banking system, especially in Europe, so the probability that bank profitability may affect global monetary policy should not be ignored. Indeed, the BoJ tweaked its policy this month which should limit the extent to which long term Japanese interest rates become negative.

In conclusion

All that said, we believe it remains difficult to interpret recent developments as representing excessively bearish news for global bonds. They may however combine to provide some medium term resistance to falls in bond yields. Given the extent to which existing policy has underpinned global bond prices (holding bond yields low), there could be some risk that long dated global bond yields may continue their recent drift higher, returning some term premium to interest rate curves.

Among all the headlines and hyperbole, it is also important to remember that major developed world benchmark 10yr government bond yields remain lower than prior to the Brexit referendum in June. Moreover, market prices for medium to long term inflation also remain low (albeit off their lows) and major global central banks continue to provide forward guidance describing an ongoing commitment to low interest rates for an extended period.

Therefore, the much heralded great rotation out of bonds may still be some time away.

Paul Morris

Portfolio Manager

Disclaimer: This is intended to provide general information only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should always speak to an Authorised Financial Adviser.