21st December 2016
Expect divergence in the monetary policies of developed economies in 2017, says Rowan Dartington’s technical investment director Guy Stephens
Last week’s decision by the US Federal Reserve’s FOMC to raise interest rates by 25 basis points had been widely expected. Markets must now consider the possibility of three further increases during 2017 as indicated by the FOMC who strive to “get ahead of the curve”. They have for some time wanted to raise policy rates more aggressively but on several occasions were thwarted by factors beyond their control. There is no doubt that those responsible for setting US monetary policy would like to have higher policy rates if only to give scope to reduce them if and when the need arises in the future. Other developed nation central banks do not have this luxury and must be extremely conscious of their inability to enact a further monetary policy response if required. One great unknown for markets at present is exactly what policies President-Elect Trump will actually pursue. This uncertainty will undoubtedly influence investor sentiment.
Given that the US now appears to be entering a period of physical expansion this will require significant additional demand for US Treasuries. It was interesting to note that Japan has now overtaken China as the largest overseas holder of US sovereign debt. This is a reflection of the Chinese running down their overseas reserves in an effort to underpin their currency. There is also the possibility that the Federal Reserve may start to sell off the US Treasuries that it purchased when undertaking quantitative easing which would place upward pressure on the yields of these assets. A significant consequence of the US raising official interest rates whilst other major economies remain committed to ultra-loose monetary policy is that the US dollar is likely to continue to strengthen. This potentially has major ramifications for many parts of the global economy and is also unwelcome for US exporters.
In the UK the monthly policy committee will remain very much focused on the domestic impact of the Brexit negotiations, which is likely to be a prolonged affair. This would insure that they look through the current pickup in inflation and will hold interest rates at the current level of 0.25% for the foreseeable future. However, this is unlikely to prevent long-term interest rates in the UK from rising; the yield on the ten-year guilt has already risen from 0.5% to 1.5% since the summer.
Whilst economic data from the EU continues to broadly show an improvement the European Central Bank (ECB) has extended its quantitative easing program until the end of 2017 albeit at a lower level. In recent days the two year German government bond has hit a record low yield of -0.78% as investors continue to price-in a protracted period of negative short-term interest rates in much of the Eurozone. Japan remains determined to re-ignite its economy by whatever means. One of the fundamental elements of this will be maintaining policy rates at around zero and markets are currently pricing in official rates still being around 0% in 2020.
2017 is set to be the year when monetary policy in the developed world diverges even further. The US is likely to be the only economy to experience policy rate increases as the other major developed economies continue to struggle with their unique set of its use. The UK faces significant uncertainty in the light of the Brexit vote, the Eurozone will be subject to several key political events which are likely to stay the hand of the ECB and Japan continues to be beset by a malaise that is decades old. This background has the potential to cause strains and imbalances to occur which may well provide opportunities from an asset allocation perspective. We continue to live in extraordinary times.