Central bankers in two of the world’s major economies have recently been discussing their thoughts on the appropriate level of inflation, and what their reactions might be to any breaching of their inflation targets. The suggestion appears to be that after a prolonged period of deflation / low inflation, authorities should be willing to tolerate a period of above-target inflation. In a speech at a Boston Federal Reserve conference in mid-October, Fed Chairperson Janet Yellen pondered on the benefits of allowing the U.S. economy to “run hot” for a period of time. She wondered whether a “high-pressure” economy would help remove some of the slack that has built up in areas such as labour force participation. Not surprisingly, the U.S. bond market reacted – bonds sold off and the yield curve steepened as investors built in some inflation premium into long-dated bonds. Over in the UK, members of the Bank of England’s Monetary Policy Committee (“MPC”) were having similar thoughts. The significant depreciation in the British Pound since the Brexit vote on June 22nd has made it very likely that the UK could face a period when inflation will exceed the MPC’s target level of 2.5%. The reason the MPC might be willing to look through this breach of target is that there is little sign of domestically generated inflation in the UK economy – virtually all of the expected rise in inflation in the coming months is likely to be attributable to Sterling’s weakness. However, mirroring moves seen on the U.S. bond market, UK gilts also sold off. Indeed, UK gilts have been the worst performing major bond market in the last 6 weeks, with significant rises in both nominal bond yields and inflation breakeven levels. Central bankers might find that once the inflation genie gets out of the bottle, it’s very hard to get it back in. Even though the authorities may persuade themselves that a little bit of extra inflation might be welcome, bond market investors know the effect that inflation has on their returns, and for those investors there is no such thing as temporary inflation.
2. European Bank Lending – Equity Performance Influences Lending Standards
At the time of the ECB’s last rate cut, President Mario Draghi made it quite clear that the ECB were keen to switch the focus away from negative interest rates and more towards the provision of credit to the real economy. Going back to the very start of the ECB’s Quantitative Easing (QE) programme, it was always made clear that one of the aims of the programme was to increase the availability of credit to small and local businesses in peripheral countries, and to simultaneously reduce the cost of that financing. That was why, at the meeting in March 2016, as well as cutting rates by 10bps to -0.40%, the ECB also introduced another Targeted Long Term Rate Operation (“TLTRO”). The aim of this programme was to offer long-term funding at attractive conditions to banks in order to further ease private sector credit conditions and stimulate bank lending to the real economy. In this second TLTRO, the interest rate to be applied is linked to the participating banks’ lending patterns. The more loans that participating banks issue to non-financial corporations and households (except loans to households for house purchases), the more attractive the interest rate on their TLTRO-II borrowings becomes. It could even potentially be as low as the deposit rate of -0.40%; effectively banks are being paid to lend money by the ECB. However, since the introduction of this second TLTRO, the take-up by European banks of these funds has been somewhat disappointing compared to initial market expectations. A chart recently produced by Deutsche Bank notes that there appeared to be a close link between the performance of European banks’ equity prices (lagged by 12 months) and Euro-wide bank lending. The chart suggested that the performance of European banks share prices in late 2015 and early 2016 might lead to a downturn in credit provision late in 2016. And so it came to pass last week, as the most recent ECB lending survey released last week showed that European banks are expected to tighten their standards for lending to corporates for the first time in nearly 3 years. Given the ongoing underperformance of European banks share prices, it suggests a bleak outlook for the availability of credit to small and medium sized European companies in 2017.
Source: Deutsche Bank, Haver, Bloomberg. Data as of 24 October 2016.
3. ECB Meeting – “Nothing to see here, move along please”
Last week’s ECB meeting was memorable only for how unexciting it was. Remarkably, in the ECB’s press release about the meeting, the only thing that was different from the press release following the September meeting was the date. ECB President Mario Draghi played a straight bat in terms of the press conference, revealing little of any note and effectively postponing all decisions. He noted that for the second meeting in a row there had been no discussion of changing the implementation or extending the asset purchases, but did clarify that no one on the Governing Council expected asset purchases to stop abruptly in March 2017. He also noted, on a number of occasions, that the ECB’s inflation outlook was predicated on a continuation of the current accommodative stance of monetary policy. These two points are important because they signal an extension of purchases beyond March 2017. That means we must wait until December for two main clarifications – how long will the programme be extended for and what will be the pace of monthly purchases? At the moment, the market consensus is for an additional 6 months of purchases with a run-rate of €80bn purchases per month, the same as is currently being bought. That leads on to some further issues with addressing the problems of bond scarcity, issuer limits and only buying bonds yielding above the deposit rate of -0.40%. Options available to the ECB include increasing the issuer limit from the current 33% to 50% or allowing individual bonds yielding below the deposit rate to be purchased as long as the overall yield on a particular maturity bucket remained above the deposit rate. In our opinion, there is no one single change that the ECB can make that will fully address the scarcity issue, so a combination of a number of changes is likely. Our view is that the ECB might disappoint market expectations in December, potentially by announcing a small reduction in the monthly purchase rate.