Central Banks Cautiously Reverse Loose Monetary Policy 

The central banks loosened their monetary policy significantly because of the financial crisis. The plan now is for it to return to normal through cautious tapering. But this will happen slowly to avoid putting too much pressure on the financial markets.

Several years into the global economic recovery, major Central Banks are finding themselves on the path to normalizing their long-standing ultra-loose monetary policies. As policy makers prepare to cautiously scale back their unprecedented stimulus measures, investors are left pondering how financial markets will digest this shift.

In the aftermath of the global financial crisis, Central Banks introduced extraordinary monetary policy measures to stimulate their economies – keeping short-term interest rates at historic lows and collectively buying trillions worth of bonds. But in recent months, major Central Banks have been hinting at scaling back their unprecedented stimulus effort, or have even started to do so.

Tapering by Central Banks: How Loose Monetary Policy Comes to an End

The Federal Reserve (Fed) has slowly begun to raise interest rates with three rate hikes over the last eight months. Moreover, Fed Chair Janet Yellen has outlined an initial plan to reduce the size of the Fed’s balance sheet by not reinvesting the proceeds of the bonds when they mature.

The Swiss National Bank (SNB) has been able to sharply reduce its foreign exchange interventions lately, as the CHF has lost ground against the EUR. A likely announcement in September this year by the European Central Bank (ECB) that it intends to reduce the pace of asset purchases starting in January 2018 would further alleviate the pressure on the SNB.

With the Eurozone economy gaining strength, expectations are growing that the days of ECB bond-buying are numbered. In his latest speech, Mario Draghi, the ECB president, offered guidance on a decision about the stimulus policy in autumn. Some investors expect an extension with a one-off reduction, while the majority see a cautious but steady wind-down (or so-called tapering) beginning at the start of 2018.

Why Tapering Is a Double Challenge for the ECB

Eurozone growth was encouragingly strong in the first half of 2017, and the outlook remains favorable. While the recovery has been strong enough for Mr. Draghi to declare the threat of deflation dead, inflation is still rather weak. At 1.3% in the year to June, the headline inflation rate is still well below the ECB’s 2% target and appears unlikely to rise meaningfully in the coming months.

The ECB thus faces the challenging task of preparing markets for the eventual tapering of monthly asset purchases while signaling that the process will be carefully managed and highly data dependent.

Tapering Balancing Act: the Difficulties Ahead for the ECB

Just how delicate the ECB’s balancing act is can be seen by the market’s reaction to a speech by Mr. Draghi at the ECB’s annual forum at the end of June. He merely stated that continuously strong economic data would warrant some adjustments of the policy parameters to keep the policy stance broadly unchanged. Nevertheless, these remarks triggered a rally by the Euro and a sell-off in Eurozone sovereign bonds.

Yet, the ECB’s biggest challenge could prove to be convincing markets that tapering, once started, may still be subject to change. If introduced too fast, tapering could derail the economic recovery through a fast-rising Euro and higher government borrowing costs.

Italy, seen as one of the countries most vulnerable to tapering, is one to watch closely. A potentially destabilizing election in 2018 means the ECB will be wary of withdrawing the safety net for one of the club’s weakest members when it needs it most.

For Monetary Policy, Tapering Means Navigating Uncharted Waters

Since 2009, Central Banks have expanded their balance sheets to unprecedented levels (see Figure 1). The expansion in Central Banks’ balance sheets has underpinned a triple recovery: (i) in the global economy, (ii) in the stock markets and (iii) in the bond markets. But what will happen when Central Banks begin to reduce their balance sheets?
It is understandable that many investors are worried about the end of a monetary policy tailwind in particular, because the impending normalization will largely be a journey into uncharted waters: Never before have Central Banks had to wind down quantitative easing measures on such a scale.

Figure 1 – Central bank balance sheets: fear of normalization of monetary policy

Figure 1 – Central bank balance sheets: fear of normalization of monetary policy 

Total assets held by selected central banks, in USD billions. Source: Credit Suisse, Thomson Reuters, IDC 

Central Banks Are Trying to Prevent Turmoil on the Financial Markets

However, the Central Banks’ extreme caution in the process so far underlines their firm intention of avoiding financial market turmoil. Furthermore, Central Banks’ officials have gone to great lengths to stress that the upcoming process shall be very gradual and take place over several years. As a matter of fact, monetary policy is by far more financial-market-oriented than is generally acknowledged. This is particularly true in the US, where the Central Bank has a double mandate of maintaining price stability and supporting overall economic development.

Given the leading position of the US Dollar on the one hand, and the intrinsic link between price and financial market stability on the other, this market-friendly monetary policy stance has become well established worldwide. Past financial market shocks induced by monetary policy decisions do not make this observation any less accurate.

Examples include the abrupt interest rate hike in 1994 or market rumors surrounding the “taper tantrum” of 2013, when bond markets reacted strongly to the announcement of the tapering by the Fed and bond yields rose dramatically due to sell-offs. Rather, such exceptions are largely viewed as monetary policy blunders and serve as a guide on how not to act in future.

How Tapering Could Impact Bonds and Equities

The prospect of tighter monetary policy is bound to affect asset classes across the board: equities, bonds, cash, real estate, commodities and currencies will all feel the effects. But it is only the impact on equities and bonds that will be examined at this point.

With monetary normalization likely to happen in a positive economic growth context, the Credit Suisse Investment Committee nevertheless retains its neutral stance on fixed income assets overall, and favors EUR financials and USD investment grade corporate bonds with a short-term expiration date in particular one to three years as we are expecting further tightening of US interest rates. European financial bonds, on the other hand, continue to offer higher credit risk premiums and appear attractive in comparison.

The Credit Suisse Investment Committee remains neutral overall in equities, but sees selected attractive opportunities in sectors and markets that offer convincing earnings trends and are not too expensive. In terms of sectors these are healthcare, energy and telecoms, whereas the Eurozone, Switzerland, Canada, and Australia remain the most favored markets.