The end of Central Bank dominance

As monetary policy shifts course, the macro risk balance will transform with it

Key Points:

  • Central banks are exiting the post-Lehman one-way street of loose monetary policy in droves which is bringing about a regime shift in monetary policy.
  • The central bank pendulum is slowly swinging from easing to tightening. From a top-down perspective, this marks nothing less than a sea change, as all the three major central banks in the world are signalling tighter monetary policy.
  • Current market optimism is partly driven by hopes for fiscal support to supplant monetary support. But fiscal dominance is a dangerous answer to the end of central bank dominance. It would deteriorate rather than improve the balance of macroeconomic risks, forcing central banks to “over-tighten” in a weak growth environment.
  • Abstaining from significant fiscal stimulus is the best response to the monetary regime shift, despite the short-term disappointments this might cause.

There is a lot of noise about the paradigm shifts looming on the horizon of political change, but whether or not conjecture becomes reality remains to be seen. There is, however, one significant change that will undoubtedly impact investors. Central banks are exiting the post-Lehman one-way street of loose monetary policy in droves which is bringing about a regime shift. This has important investor implications, as the almost universal monetary support for asset returns and macro stability is being eroded.

Although a headwind to growth, monetary tightening as such is not a bad thing when the economy is heating up. But if significant fiscal stimulus is added to the policy mix, it might bring us closer to the end of this cycle rather than prolonging it, as many are currently thinking. Consequently, this link also is a key determinant for whether current market optimism is justified.

The central bank pendulum is slowly swinging from easing to tightening. From a top-down perspective, this marks nothing less than a sea change, as all the three major central banks in the world are signalling tighter monetary policy. In the wake of rising optimism in the US economy, the Fed has entered the early stage of an interest rate hiking cycle. Although thus far a shallow hiking path, the risk right now is tilted towards hawkish surprises from the Fed. If better sentiment translates into higher growth, the world’s most important central bank might even consider a reduction of its balance sheet in a not too distant future, adding unconventional to conventional monetary tightening. In Europe, the ECB is reducing the pace of its bond purchases and rising inflation has produced more hawkish voices in and around Frankfurt’s Euro Tower where rate hike expectations are beginning to appear on the monetary policy horizon. Finally, even the Chinese central bank is on a tightening course — it was actually the first major central bank to raise rates in 2017. An extremely easy monetary policy has been one of the main drivers behind remarkable macro and market stability since the Great Financial Crisis. Consequently, as monetary policy shifts course, the macro risk balance will transform with it.

From monetary to fiscal dominance? Be careful what you wish for

So how will this regime shift impact the overall macro risk balance and, therefore, market direction? Crucially, the outcome is dependent on the interaction between fiscal and monetary policies, particularly in the US. The difference compared to earlier tightening cycles is that growth – although improving – is much weaker than it was before the crisis. The addition of elevated political uncertainty has rendered the macroeconomic foundation shaky at best. Hence, many investors are hoping that fiscal dominance will replace central bank dominance, leaving the overall macro risks unchanged. The theory goes like this: As fiscal support would replace central bank support, this would then lift growth and asset prices further.

But this might be wishful thinking. Fiscal stimulus is not reducing macro and market risks at the current juncture. To the contrary, opening the fiscal spending spigots actually increases macro risks when economies run at full capacity, like the US is doing. It sows the seeds of overheating further down the road, forcing central banks to counteract. Keep in mind that fiscal stimulus expectations are an important reason for Fed tightening in the first place. In a structurally weak growth environment, bold fiscal stimulus could therefore derail the recovery indirectly, as it would force central banks to tighten more forcefully than currently expected.

Monetary policy and fiscal policy are complements, not substitutes. If significant fiscal stimulus were to happen in the US, more Fed tightening would be unavoidable. At best, this would neutralise the fiscal impact on growth. At worst, it would create a vicious feedback loop, strangling the recovery in the private sector that is already happening. The world is still awash with debt, more so than during the heights of the credit crisis. This amplifies the potential negative effects of central bank tightening. Market optimism based on a one-sided focus on the positives of government spending waves is therefore misplaced. Instead of lifting growth and returns it would increase downside potential.

The bottom line: Less is more

The end of central bank dominance marks a regime shift. The impact on market direction is a reflection of how the overall balance of macroeconomic risks will be affected. In this context, fiscal response from governments will be key. Current market optimism is partly driven by hopes for fiscal support to supplant monetary support. But fiscal dominance is a dangerous answer to the end of central bank dominance. In fact, it would deteriorate rather than improve the balance of macroeconomic risks, forcing central banks to “over-tighten” in a weak growth environment. The recent hawkish signals from the Fed can be seen as an early warning sign. In this case, less is actually more: Abstaining from significant fiscal stimulus is the best response to the monetary regime shift, despite the short-term disappointments this might cause.

About Nordea Asset Management
Nordea Asset Management (NAM, AuM 217 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 323 bn EUR*). NAM offers European and global investors exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients.  NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

 *Source: Nordea Investment Funds, S.A., 31.12.2016

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