Published : 6 years ago, on 13/09/2018

In his Q4 Economic outlook, Neil Williams, Senior Economic Adviser to Hermes Investment Management, argues that even a decade after the fall of Lehman Brothers – central banks will be slow to lift a tide of liquidity still hiding the rocks beneath.

Letting the tide go out…

Ten years after the fall of Lehman Brothers, major economies have more than recouped their real GDP.

Much of this can be accredited to nine years of monetary stimuli – conventional and unorthodox – that was unparalleled since the 1930s.

Therefore, with recoveries now maturing, unemployment rates down and asset prices bloated by a decade of cheap money, central bankers sound more hawkish – suggesting an inflection point. However, the reality is they will be slow to lift the tide of liquidity still hiding the rocks beneath.

As a result of QE, the world’s big four central banks‘ balance sheets have surpassed $15trn. This means about 40% of the world’s $25trn central bank assets has amassed in just nine years. That is, after the last US recession ended in mid-2009.

This injection to the private sector is equivalent to about one half of US GDP or three-quarters of China’s. Furthermore, of the four central banks, three are by their own definition (that it’s the stock that matters) still running QE, with little convincing sign of stopping.

However, QE has only been partially successful. It helped unclog the financial system in 2009, but by inflating asset prices since, later rounds of it could be accused of getting to those that needed it least.

On the premise that QT’s effects will be the corollary of QE’s, a fear is that quantitative tightening (QT) now contributes to an asset-price deflation that throws away the ‘baby’ (recovery) with the bath water. This risk is probably most acute in the long-rate sensitive US and euro-zone.

Yet, the US Fed is the test-case for QT, and could be underestimating its effect. By sustaining it, the Fed could take out as much as 175bps of further rate hikes by 2020. In which case, the Fed will fall easily short of their preferred 3.25-3.50%, ‘Goldilocks’ policy rate (i.e. not too hot, not too cold). 

History of UK’s main policy rate since 1694

Moreover, we still doubt the BoE will get as far as the 1.5% Bank Rate it craves before starting QT. Its own 3% ‘Goldilocks’ rate looks even more remote. Even if the MPC achieves this, it will sit below its 5% average since the Bank was established in 1694.

To put this into historical perspective, next March when MPC members look back on a decade of hardly-changing rates (just 0.25 to a possible 1.0%), they may take heart that, compared to the 18 years around World War II and the 100 years after the South Sea Bubble, a decade of stability may be considered short lived! (See chart above)

This is just as well if retaliatory trade protectionism – the unhelpful, missing jigsaw-piece from the 1930s – comes crashing into place. China’s commitment to US Treasuries would be questioned amid competitive currency depreciations, and there would be increasing strains on those emerging markets, including Turkey, that have the biggest short-term US dollar needs.

Lifting the weight off bond yields will be a long, drawn-out process

The ‘splint’ of cheap money and QE will thus persist. And, as we know from Japan, the main benefit is to keep yields low for even longer – as other QE countries now attest (see chart above).

Therefore, even a decade on, we probably face another two years of negative-to-flat real policy interest rates in the G5 countries – with the attendant pressures still on savers and many pension schemes. 

The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.