economist insights 2013 09 022
TRANSCRIPT
7/30/2019 Economist Insights 2013 09 022
http://slidepdf.com/reader/full/economist-insights-2013-09-022 1/2
Economist Insights
One-downmanship
2 September 2013Asset management
In the past few months, the two largest central banks in
Europe have changed their approach to monetary policy and
adopted forward guidance of one form or another. The Bank of
England (BOE) has introduced a threshold guidance based on
unemployment, similar to the US (see Economist Insights,
12 August 2013). The European Central Bank (ECB), meanwhile,
has introduced a more “flexible” time-based guidance.
Forward guidance can be considered the frontier of current
thinking in monetary policy. Quantitative easing (QE) used to
be the frontier, but doubts about its effectiveness combined
with concerns about the side effects have encouraged central
bankers to look for alternatives. With policy interest rates
close to their zero lower bounds, it is hoped that forward
guidance can stimulate the economy without the central
bank actually having to do anything. A central bank can
commit to keeping interest rates low for longer than the
expected pace of economic activity would normally suggest.
The trick with forward guidance is that while the central bank
cannot in practice push the policy rate into negative territory,it can keep real rates (accounting for inflation) negative for
longer and, in theory, incentivise people to bring forward
consumption and investment.
Judging by the market reaction since its introduction, forward
guidance in Europe is at risk of being remembered as one
of the most unsuccessful experiments in monetary policy.
Instead of keeping rates lower, the sovereign yield curve
has actually steepened significantly in both the UK and the
Eurozone. Markets are now pricing in two rate hikes in the
Eurozone and three in the UK by the end of 2015 (see chart).
This is in spite of the BOE’s announced intention not to hikerates before 2016 and the ECB’s guidance that it expects
to remain on hold for an “extended period of time” that
goes beyond the policy-relevant horizons (which for the ECB
would mean close to 2016).
Joshua McCallum
Senior Fixed Income Economist
UBS Global Asset Management
Gianluca Moretti
Fixed Income Economist
UBS Global Asset Management
The misunderstanding
Central bank policy rate as implied by forward guidance and market
expectation by Dec. 2015
Source: Bloomberg, UBS Global Asset Management
Note: Market pricing is based on EONIA and SONIA, making the assumption that the
basis spreads between the central bank rate and these rates are constant. The basis
spread could vary due to changes in quantity of central bank reser ves in the sys tem.
A) Bank of England
B) ECB
C) Federal Reserve
Both the ECB and Bank of England have recently adopted
forward guidance of one form or another. But judging by
market reaction, this seems so far to have been unsuccessful
and the recent improvement in the economic outlook has
not helped. Forward guidance in Europe is also impacted
by rising US bond yields. While the ECB and the Bank of
England in theory have the necessary levers to anchor short-
term rates, they may need to engage in ‘one-downmanship’
to convince markets that their economies are not as strong
as the US and therefore their yields do not need to rise as
aggressively as the market is currently pricing.
0.25
0.50
0.75
1.00
1.25
1.50
0.25
0.50
0.75
1.00
1.25
1.50
0.25
0.50
0.75
1.00
1.25
1.50
Forward guidance for Dec. 2015Market implied
Aug-13Jul-13Jun-13May-13
7/30/2019 Economist Insights 2013 09 022
http://slidepdf.com/reader/full/economist-insights-2013-09-022 2/2
There are two main reasons why the markets have not reacted
to forward guidance as the central banks would have hoped.
The first is that markets may not think that the commitment
is credible. Markets expect that the central banks will revert
to their standard reaction function as soon as growth and
inflation start to rise.
This is likely to be particularly true for the ECB. The ECB is
arguably the least committed among the forward-guiding
central banks. In contrast to the BOE or Federal Reserve,
the ECB has no leeway to interpret its mandate flexibly to
justify remaining on hold for a specific length of time. The
ECB’s forward guidance is really just telling the market that
it expects growth and inflation to be low enough to allow
rates to be unchanged for an extended period of time. If
markets think that those expectations are too conservative,
then they will expect the ECB to break its promises at the
first whiff of inflation.
The second explanation for the apparent failure of forward
guidance may be that the market sees the timeframe to reach
the central bank’s threshold as too pessimistic. This could well
be the case in the UK, as with current unemployment at 7.8%markets might believe that threshold of 7% will be achieved
earlier than 2016 as the Bank of England forecasts.
One thing seems to be sure – the recent improvement in the
economic outlook has definitely not helped the effectiveness
of forward guidance. GDP growth in the UK and Eurozone
surprised substantially on the upside in the second quarter.
Furthermore, survey indicators such as the purchasing
manager indices have recently moved to their highest values
since mid-2011. Seeing a stronger economy, markets have
rapidly re-priced their expectations for the future path of
monetary policy.
Forward guidance in Europe is also imperilled by rising bond
yields in the US. Yields on gilts and bunds have risen in
correlation with US treasuries as investors accelerated their
withdrawal out of safer sovereign bond markets. In contrast to
Europe the market expectation for the US rate path is arguably
far more aligned with the Fed’s projections and is warranted
by the resiliency of the recovery. But historically European
government bonds have moved in sympathy with the US, so
the big challenge for the BOE and the ECB will be to limit the
contagion from the US once tapering of QE begins. When
markets start pushing yields above levels that are appropriate
for the economy, the recovery is put at risk because borrowingcosts are rising too fast.
What can a forward-guiding central bank do to counteract
this kind of contagion? The first option would be to wait
and see if the recovery is strong enough to withstand the
higher rates, taking the risk that this could result in weaker
economic activity. If the recovery is not strong enough, then
market expectations should automatically correct as soon as
the recovery begins to falter (and hopefully this would not
be too late to reverse the damage). Alternatively, the central
bank could act to anchor interest rates even more securely
at the front end of the curve, until certain that the recovery
is on a sustainable footing. While this would have little
impact on the long end of the yield curve, in the UK and the
Eurozone this is far less important because most lending to
the private sector is linked to short-term rates. Furthermore,
a steeper yield curve would make sense as long as the central
bank believes that the recovery is in place and only wants to
prevent short-term spillovers to the economy from markets
getting ahead of themselves.
Both the ECB and the BOE in principle have the necessary
levers to anchor short-term rates. The first tool is clearly all
about communication and the threat of intervention. Yet
communication has not worked very well so far. The ratherdovish first public speech by the new BOE Governor Mark
Carney failed to convince markets. It is likely, however, that
the effectiveness of communication will improve the higher
interest rates go.
If communication does not really work, both central banks still
have the option to cut the policy rate. While the threshold for
such action is still very high, it cannot be completely excluded,
especially if the recovery starts to show some sign of softening.
Given that there is really only room for one further cut, both
central banks may be inclined to keep this move in reserve.
Alternatively, the Bank of England could be bold enough to
expand QE at the front end of the curve while the ECB could
launch a new 12-18 month fixed-rate long-term refinancing
operation (LTRO).
We are used to politicians engaging in one-upmanship when
talking about their economies: they always want to talk
about why their economy is better than anyone else’s. For
the ECB and the BOE, the challenge will be convincing the
markets that their economies are not as strong as the US and
therefore their yields do not need to rise. If they fail in this
‘one-downmanship’ then the markets risk proving the central
bankers right and stifling the recovery.
The views expressed are as of September 2013 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio andfund-specific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. This document is intendedfor limited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publicationwithout the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is acceptedfor any errors or omissions herein. Please note that past per formance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value ofinvestments and the income from them may go down as well as up and investors may not get back the original amount invested. This document is a marketing communication.Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdictiondesigned to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. Theinformation contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund.
The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in goodfaith. All such information and opinions are subject to change without notice. A number of the comments in this document are based on current expectations and are considered“forward-looking statements”. Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of UBS Global AssetManagement’s best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, futureevents, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, marketsgenerally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund.
© UBS 2013. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 23298