This was first published on Netwealth – 21 September 2023
The unintended consequences of aggressive monetary policy tightening in western economies continues to be a concern, both for the economic and financial market outlook.
The speed and scale at which interest rates and bond yields have risen over the last couple of years have triggered significant shocks, although at times other factors have also played a part. Examples include the UK’s liability driven investment (LDI) crisis last autumn and the collapse of Silicon Valley Bank and the subsequent run on regional US banks earlier this year.
We need to be mindful of a few other aspects now. On the policy tightening front, there has already been much attention focused on whether policy rates may rise too far. That remains a risk, although this fear may now be receding in the wake of latest data. But there are other aspects of policy tightening that merit attention.
Central banks’ balance sheets
One is that even when policy rates have peaked, policy tightening is likely to be still ongoing via quantitative tightening (QT) in the US, UK and euro area. Central banks seem to still view this as a technical exercise, without grasping fully the way its predecessor, QE (quantitative easing), and now QT have a wider economic and market impact, too.
In the UK, for instance, it will surely keep bond yields higher than otherwise, at a time when the economy will be losing momentum. It also feeds into the wider issue that we have commented on previously, about the cost to the taxpayer of QT and about the interest that has been paid to banks on their reserves at the Bank of England, and whether a tiered system should have been introduced some time ago.
Furthermore, as the OBR (Office for Budget Responsibility) has previously pointed out, QE has significantly reduced the maturity of UK government debt, thus making it more sensitive to the higher rates that we have seen. It also should highlight the policy error that the UK did not borrow more longer-term debt at close to zero longer-term interest rates when it had the opportunity. What an ill-thought through policy this has all been.
A key relevance is that once policy rates have peaked, markets may likely focus on the reduction in central bank balance sheets. One dilemma might be that while from a future economic perspective it may be sensible to avoid a return to cheap money and to instead have a prolonged period of high positive real interest rates once inflation has decelerated. Then a pivot to lower rates may not only be demanded by the markets at the first sign of sustained economic weakness, but may also be beneficial for western central banks selling their bonds as they reduce their balance sheets.
Global liquidity
The actions of the Bank of Japan continue to warrant close attention, as I have stressed before. Japan’s extended period of both low policy rates and low, controlled bond yields has meant Japan has been an important source of funding and of global liquidity.
Now, policy normalisation is under way there, too, but Governor Ueda appears to be focused on gradualism, mindful of how the economy may be moving away from the risk of deflation and conscious of managing market expectations. I remain positive about immediate economic prospects there, but we need to watch closely how this impacts global liquidity.
Likewise, too, with developments in China. The weakness of the renminbi is significant. It’s also indicative of the headwinds that have been facing so-called emerging economies. The fiercest part of these headwinds has been higher US rates and a firmer dollar which is undoubtedly forcing difficulty upon many firms who have borrowed overseas at previously low rates and are now facing higher debt servicing costs.
The weaker renminbi reflects this, as well as the divergence in policy rates between the US and China, which sensibly is gradually cutting rates.
A weak renminbi will add to competitive pressures across Asia. The headwinds have also included a loss of momentum in global trade. A move from globalisation to protectionism and to fragmentation may also be playing a part, impacting some. Monetary policy easing is not just evident in China, but also elsewhere such as Brazil and Chile.
Earlier this year, the Bank for International Settlements’ (BIS) data showed that while cross-border lending was still rising in the first quarter the pace of credit growth had slowed since the middle of last year, through into the first quarter of this. This trend will likely have continued, as policy rates have risen and banks seek repayments and bolster their capital positions.
The interconnectedness of the financial system, which was a concern after the 2008 crisis, remains. Credit to the non-banks financial institutions (NBFIs) has risen the most in recent years, with the BIS reporting that their share in global bank cross-border credit reached 22% in the first quarter. This warrants attention as the full impact of policy tightening and higher yields feeds through.
NBFIs include a wide array of institutions such as pension funds, insurance companies and other financial intermediaries. They accounted for about half of the $468.7 trillion of global financial assets at the end of 2021, which is when the latest data from the Financial Stability Board relates to. Then NBFIs assets were $226.6 trillion. The end of 2022 data should be out before year-end.
This annual assessment of the shadow banking sector highlights how global liquidity provision has changed since 2008, away from banks towards shadow banks. A worry has to be the extent to which bonds count as core collateral for them, and thus the sheer rise in yields over the last year will feed into tougher liquidity conditions globally. NBFIs, like many banks, will surely tighten lending criteria.
Those central banks across emerging economies who adopted prudent policies previously are already starting to ease policy. Meanwhile, policy rates in the west, including the UK, US and euro area should now be nearing their peak. But previous tightening has still to feed through. Moreover, a tightening of global credit conditions is still unfolding, and that may take time to fully feed through, which will further dampen global growth.