Therefore they have perhaps – or most probably – been wrong-footed by the markets’ rather negative reaction to the promises of yet more QE / negative rates / more monetary experiments. We suspect that many people simply believed that the markets could not have too much of a good thing, although as we all know that is rarely true in the real world...

For our part, we have tended to view the Fed’s QE1 in 2009 as having been, if not exactly a good thing, then a necessary one that was needed in order to prevent a worse collapse within the financial system. We have certainly never viewed the subsequent iterations of QE as being anything other than distortionary miss-adventures, or at best simple placebos for the markets. Unfortunately, we suspect that we have now reached the point at which QE-style experiments are already beginning to do more harm to the world economy than good.

For example, we remain convinced that negative rates are exceptionally toxic to any country’s banking system, its pension companies and insurers, and most of all its renters who, in an era of aging demographics are becoming an ever more important subset of the general population. Indeed, there is now ample evidence from not only the crisis-hit 1970s but also, and more importantly, the much more recent data that suggests that ultra-low / negative rates will lead a population not to spend more but rather to attempt to save more of its incomes. 

In fact, we have noted with some degree of alarm over the last year how as (real) interest rate expectations collapsed below some notional ‘critical perceived level’ in Germany, Japan, France and even Italy, the population has responded by attempting to save more so as to rebuild or defend the perceived net present value of their pension pots (i.e. they have a target terminal level for their real savings that negative interest rates makes it harder to hit...).

Of course, higher saving, particularly in the context of a period of lacklustre corporate capital spending trends (such as we have today), cannot be expected to lead to faster rates of economic growth in the short to medium term; saving is after all “not spending”. Therefore, we have long thought that ultra-low, let alone negative, rates are always likely to be less than helpful to the underlying economy. 

Moreover, negative interest rates have long been recognised by central bankers and bank analysts (if not many macro economists) as being essentially highly toxic for the financial systems of any of the countries that adopt them. By way of an example, a well-placed source once told us that the Swiss private bank for which he then worked had witnessed an 85% decline in its profits when the Swiss National Bank went negative (largely caused by the fact that the banks could not afford to pass on negative interest rates to their depositors for fear of losing their core financing and hence their businesses) and consequently we, at the time, failed to see just how this could be remotely good news for the economy (let alone the financial system). Therefore, it was of no surprise to us to find that credit growth slowed in Switzerland following the move to negative policy rates and even in the more buoyant Swedish economy, it is not clear that negative rates have provided a stimulus to the credit system.

For us, the most shocking part of the whole negative interest rate game is that despite all of these observed and quantifiable problems and disadvantages that accompany any move to negative rates (and some others that we have not discussed here, including the impact of the ECB’s QE on the intra EU TARGET2 settlement system), the central banks seem to be going there regardless. To us, this seems a truly remarkable event given that we know from countless one-on-one meetings that many of the Banks’ own research and policy divisions were more than aware of these issues and so it would seem that the various Boards of the central banks have in effect gone against the advice of their own internal advisors.

As to why this has happened it is not entirely clear. The Boards may have been under political pressure to do something; they may have been snubbing the OECD’s recent warnings at Davos that the policy arsenal was empty; or they may simply now be caught in a lie. In reality, we suspect that it is the latter explanation that is the most compelling but, having told one lie (i.e. that QE would lift economic activity), the central banks now seem intent on telling ever bigger lies to justify the first ones – clearly they are not in George Washington mode! 

Of course, as every child knows, sooner or later the lies are revealed and the credibility of the liar is irrevocably damaged and we are beginning to suspect that the politicians may have started to force the central banks to reach this point. We suspect that there may be yet another ever more illogical push into even more negative territory by the ECB and perhaps even by the BoJ but we do believe that the central banks are very close to being “found out. At that point, the warnings from OECD Finance Committee Chairman White, that were delivered at Davos, may well turn out to have been very prescient indeed. Moreover, we suspect that risk markets will continue to take a very dim view of any further monetary experiments by the major central banks.

There is of course a (logical) argument that flows from the above that, if more QE and negative rates are ‘bad’ for economies, then should less QE and higher rates be ‘good news’?  Interestingly, and crucially, we would suggest that this has indeed been true in one particular (and very important) economy. Specifically, we find that although the FOMC has raised interest rates and, in order to achieve this rate hike, it has been obliged to implicitly remove between one half and a third of the liquidity that it added in QE3, the fact is that US bank credit growth has accelerated since the FOMC signalled higher interest rates.

Admittedly, the US bank credit data was probably affected by a year-end spike (largely driven by activity within the short term repo markets) but in general we do find that the mortgage data and the commercial sector lending data have started to look somewhat better on a trend basis since the FOMC raised rates. We believe that this has occurred because the move away from zero has in practice given the commercial banks the prospect of higher margins and therefore increased their willingness to lend significantly.

Certainly, we can argue that given the level of excess reserves that the commercial banks have experienced over the last 5 – 6 years, and the banks’ still low loan to deposit ratios, it was never a simple funding constraint that was limiting credit growth in the US. It may instead have been a lack of potential returns to new lending that was constraining the banks.  However, this problem has now been eased with the result that credit growth has picked up to what is now a quite robust pace.

Given this outcome, we can see no reason why the FOMC would wish to move official rates back down (although the still relatively low level of the loan to deposit ratio may of course keep the actual effective deposit rate below zero for some time to come).

Unfortunately, there is perhaps one complication to the US monetary policy story, which is the US corporate bond markets. Partly we suspect as a result of the impact of the fall in the oil price on the oil producing sectors, but also as the result of an unintended consequence of the FRB’s increased level of reverse repos (something that was necessary to force short term rates higher but which will have lowered the demand from the financial sector for corporate bonds to use as collateral), the corporate bond markets have clearly weakened. Over time, we suspect that this weakness will result in the brokerage community starting to ‘ration’ the access of corporates to the fund raising within the markets, something which will represent an effective tightening in credit conditions for not only large corporations but also for the equity markets that have for much of the last decade been heavily reliant on the flow of equity-buy-back capital that was itself being funded from the bond markets.

However, given that the FRB was reportedly concerned by the quantum of corporate zaitech that was occurring, we doubt that the central bank will be too concerned by any slowdown in this level of activity.  Therefore, while it could in theory be argued that perhaps the FRB should not have attempted to tighten late last year given the weaker data that is being reported not just by many overseas economies but also by the USA itself, it seems to us that so far at least the net impact of what the Federal Reserve has actually done has been to improve the supply of conventional bank credit while potentially curbing some of the excesses that were occurring in the corporate bond markets.

Therefore, whether by design or simple good fortune, the FOMC’s last move should at this juncture be viewed as a success and a reason for the Fed to stay put for the next 6 – 9 months.  This should, quite justifiably, provide the US Treasury and perhaps even its equity markets with at least a degree of relative support over the medium term but, for much of the rest of the Northern Hemisphere, the pre-occupation amongst policymakers for negative rates and more QE may continue to act as a ‘counter-intuitive’ drag on particularly risk market returns – and ultimately their currencies.

Andrew Hunt
International Economist, London

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