Ultra-Loose Monetary Policy Supporting Atypical Recovery

Good economic data out of the US, including very positive small business sentiment indicators, and the UK, with a blockbuster employment report out on June 11, provide further evidence that global growth is set to accelerate as 2014 progresses, in line with our view. That is not to say, however, that a rising tide is carrying all ships. The eurozone remains a major weak point in the global economy with persistent sluggish growth and dangerously low inflation motivating the European Central Bank (ECB) to deliver a range of monetary easing measures on June 5. On this note, perhaps the most striking feature of the global economy at present is just how loose monetary policy is and how low fixed income yields have dropped. In addition to recent ECB easing, the central banks of China, Mexico and Turkey have recently eased monetary policy. At this stage, we estimate that countries representing just over 50% of global GDP are running zero interest rate policies, including three of the four largest economies in the world (US, eurozone, Japan).

This is having a significant impact. Bonds have rallied, with peripheral eurozone yields in particular going to absurdly low levels. The chart below shows that Spanish 10-year government bond yields are now below the previous lows recorded in 2005, having been caught up in the turbulence of the eurozone sovereign debt crisis only 18 months or so ago. Greek 10-year yields at 6% stand out even more and suggest that the global economy has entered unchartered territory. Indeed, Greece underwent the biggest sovereign debt restructuring in history as recently as 2012, and the debt load today is higher than what is was before the first bailout commenced in 2010, but demand for the most recent Greek 5-year issue was nonetheless heavily oversubscribed.

Given that we expect the euro to depreciate versus the US dollar, and considering the very low (and falling) yields on eurozone sovereign debt, US treasuries look all the more attractive. So long as 10-year bonds in Japan are yielding 0.6%, and Spanish and Italian yields are yielding under 3.0%, it is difficult to see their US equivalents rising much beyond 2.8% for the time being.

UK Posts Record Job Gains
UK - Employment Change, 3m/3m

Good economic data out of the US, including very positive small business sentiment indicators, and the UK, with a blockbuster employment report out on June 11, provide further evidence that global growth is set to accelerate as 2014 progresses, in line with our view. That is not to say, however, that a rising tide is carrying all ships. The eurozone remains a major weak point in the global economy with persistent sluggish growth and dangerously low inflation motivating the European Central Bank (ECB) to deliver a range of monetary easing measures on June 5. On this note, perhaps the most striking feature of the global economy at present is just how loose monetary policy is and how low fixed income yields have dropped. In addition to recent ECB easing, the central banks of China, Mexico and Turkey have recently eased monetary policy. At this stage, we estimate that countries representing just over 50% of global GDP are running zero interest rate policies, including three of the four largest economies in the world (US, eurozone, Japan).

UK Posts Record Job Gains
UK - Employment Change, 3m/3m

This is having a significant impact. Bonds have rallied, with peripheral eurozone yields in particular going to absurdly low levels. The chart below shows that Spanish 10-year government bond yields are now below the previous lows recorded in 2005, having been caught up in the turbulence of the eurozone sovereign debt crisis only 18 months or so ago. Greek 10-year yields at 6% stand out even more and suggest that the global economy has entered unchartered territory. Indeed, Greece underwent the biggest sovereign debt restructuring in history as recently as 2012, and the debt load today is higher than what is was before the first bailout commenced in 2010, but demand for the most recent Greek 5-year issue was nonetheless heavily oversubscribed.

Unchartered Territory
Spain - 10-Year Government Bond Yield, %

Given that we expect the euro to depreciate versus the US dollar, and considering the very low (and falling) yields on eurozone sovereign debt, US treasuries look all the more attractive. So long as 10-year bonds in Japan are yielding 0.6%, and Spanish and Italian yields are yielding under 3.0%, it is difficult to see their US equivalents rising much beyond 2.8% for the time being.

USTs Still Attractive?
US - 10-Year Government Bond Yield & MSCI World Discretionary To Staples Ratio

And should the wall of foreign liquidity result in US yields breaking below 2.40%, and heading toward 2.00% at a time when the US economy is picking up steam, it would help the US recovery accelerate by lowering borrowing costs. This is important in the case of long-term mortgage rates, which had increased late last year and threatened to choke off the US housing recovery. While it is true that the Federal Reserve is still set to stop expanding its balance sheet by the end of the year, and will begin hiking rates by the end of 2015, global demand for USTs is likely to keep a lid on long-end yields. By historical standards, global monetary policy will remain extremely loose even in the face of modest rate hikes in the US and UK.

For developed markets struggling with tepid growth and deflationary pressures - which is most of them, with a few exceptions, including the US - the rise in liquidity and the promise of low borrowing costs is no guarantee of a sharp improvement in growth. Also required is a mechanism for transmitting these conditions into the wider economy: namely, credit expansion. The US has turned the corner in this respect, with US domestic nonfinancial debt growth above 4% y-o-y for the past two years.

Credit Growth Mixed
Global - Credit to Private Non-Financial Sectors, % chg y-o-y

In contrast, the eurozone is not in nearly as good shape. The total stock of credit to households and non-financial corporates fell 1.6% y-o-y in April and we believe that the credit gap is at least EUR1trn at this stage. Even with the ECB unveiling a raft of measures aimed at warding off the risk of deflation (from a negative deposit rate to targeted cheap loans to the banking sector), the efficacy of stimulus measures will be undermined by the lack of structural economic reforms.

The challenges facing emerging markets are no less daunting. Although EMs have more fiscal and monetary ammunition available relative to developed states which have exhausted traditional policy tools, the transition towards new economic growth models will lay bare those that failed to pursue structural reforms during the boom years. While the outlook for emerging market growth is still much stronger than for the developed world, the economic trajectory is nonetheless weaker than during the last cycle, and will likely be bumpier too.

Similar to developed states, EM equities and local fixed income will continue to benefit from loose global monetary policy. Indeed, the record low government bond yields that we have seen in heavily indebted eurozone periphery states can also be seen across emerging markets, even for those with a tumultuous credit history. The story for EM equities is similar, with the chart below showing the MSCI emerging market equity and local debt indices continuing to edge higher.

EM Equity And Fixed Income Benefitting From Loose Monetary Policy
Global - MSCI Emerging Markets Equity & Local Debt Indices

The recent drop in developed world interest rates is certainly having a part to play, particularly for those EM economies pressured by large external deficits. While this bodes well for the near term outlook, we warn that monetary tightening in the US (and also the UK) is only a matter of time, and when it comes it will revive stresses in those economies continuing to run large current account deficits, and could materially weaken global economic growth further down the road.

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