Why rates are on hold, and may stay that way

02 May 2019 | Markets and Economy


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Commentary by Vanguard Senior Economist Alexis Gray.

Economic activity has slowed, putting central bank interest rate 'normalisation' on hold, again. What should investors expect?

What lies behind the sudden change in interest rate expectations? Six months ago we were reasonably comfortable that rates were on an upward course. Tax cuts were pumping oxygen into the US economy, which was adding jobs at a rate of around 200,000 a month. The euro area was at last coming back to life, even to the point of looking like one of the better performing regions. Brexit, however disorderly at a political level, had so far failed to puncture the UK economy.

Central banks felt that they were on course to deliver the long-awaited and much-heralded normalisation of monetary policy. Gradually, over three and a half years, and through nine increments, as of March, the Federal Reserve had nudged the overnight funds rate from 0—0.25% to 2.25—2.5%. Rates were expected to rise a further 0.5—0.75 percentage points this year, spread over two or three hikes. Since October 2017, the Fed had also been running down its enormous balance sheet, at a rate of around US$30 billion a month.

The US was definitely in the lead when it came to large-economy, developed market recovery. But other central banks were also feeling renewed confidence. The European Central Bank, following the Fed, had stopped adding assets to its balance sheet and was on course to start raising rates later this year. Should Brexit go smoothly, there was the looming likelihood that the Bank of England would restart raising interest rates too.

That view no longer holds. Major central banks across the world have now signalled that they will put their current monetary policy normalisation plans on hold. The shift in normalisation plans was arguably forced on central banks because of a sharp slowdown in global economic activity, which was exacerbated by elevated levels of political uncertainty and tighter financial conditions.

It is no longer clear if the Federal Reserve will raise interest rates this year. Indeed, there is a growing possibility that the next move in rates may be down.

In other developed markets, the picture has also dimmed. The euro area has lost a great deal of momentum, with Italy falling into technical recession and Germany narrowly avoiding the same fate. In the UK, growth slowed markedly in the fourth quarter, falling to 0.2% from 0.6% in the preceding period, a fall most likely compounded by the uncertainty of Brexit.

The US saw similar softness, with growth easing over recent quarters. The government shut-down was a further negative, as were the global slowdown in manufacturing and the escalating trade dispute with China.

In China itself, the stall on trade has taken some of the wind from growth, with Q4 seeing the third consecutive decline in GDP. An additional factor appears to be weakness in the 'new economy', sectors such as consumer goods, high-skill manufacturing and services.

As a consequence, central banks, including the Fed, the ECB and the Reserve Bank of Australia have been quick to acknowledge global weakness, and promised to keep rates on hold until the outlook improves. Against a background of cooling global growth, monetary policy normalisation will remain largely on hold this year and possibly even longer.

We expect global growth to gradually recover from the recent trough as short term risks fade. Overall though, global growth is likely to ease from 3.7% in 2018 to 3.3% in 2019. Were growth to weaken further, central banks may feel the need to loosen policy, but this may prove difficult in some parts of the world where interest rates remain close to zero and balance sheets are swollen. It is striking that more than 10 years on from the global financial crisis, interest rates have failed to normalise across any developed market other than the US, and may fail to do so for at least several years.

The lack of manoeuvrability is only made worse in that the new post-crisis 'normal' for interest rates is significantly lower, due to falling productivity growth and an ageing population. Our estimated future equilibrium real rate is around 0-1%, compared with 2-3% pre-crisis.

The implications of easier monetary policy for equity prices should be supportive in the short run, helping to offset the negative impact of lower growth on corporate profits. The overall return on global bond portfolios will remain low as we head into the next decade, with expected returns of 0-2% for sterling denominated portfolios. But the good news is that the risk of a rapid fall in bond prices due to a sharp rise in interest rates has diminished.

US vs Developed Market Growth

Source: Macrobond, Vanguard

Alexis GrayAlexis Gray
Vanguard senior economist

All data sourced from Macrobond

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