Riding the wave of easing

The wave of monetary easing

Monetary easing and interest rate cuts are making headlines all over the world. In the first week of July, the Reserve Bank of Australia reduced its policy rate by 25 bps. Then on 18th July, the Bank of Korea surprised with a rate cut for the first time since 2016. On the same day, Indonesia and South Africa lowered their respective benchmark rates, both for the first time in almost two years. 

All these policy changes (rate cuts) are no different from what’s been happening in New Zealand, Indonesia, India, Malaysia, and the Philippines – central banks in all of these countries have already eased this year and collectively underscore the global nature of the brewing rate-cutting cycle. 

Among all these countries, while China may seem like an outlier, it must be understood that the People’s Bank of China (PBOC) has slashed the amount of cash that the banks must hold as reserve six times since early 2018 to help turn around the soft credit growth trends. Even though the PBOC has not touched its key lending-rate (base rate) for a long time, it has injected large amounts of liquidity into the financial system and guided short-term interest rates lower. This is to say that monetary easing is somewhat different and targeted but happening in China as well.

What about the Big 4?

Even though there has been a significant change in the rhetoric of the big four central banks, they haven’t moved in terms of interest rates just yet. The US Federal Reserve, the European Central Bank (ECB), the Bank of England (BOE), and the Bank of Japan (BOJ) are referred to as the Big 4 banks.

However, any judgment regarding the timing and nature of monetary easing from the Big 4 banks should be done taking into account two important factors. One, for most of the G4 central banks, monetary easing is likely to be more in terms of QE (balance sheet expansion) rather than rate cuts. Two, when it comes to multiple rate cuts, apart from the US Fed, the rest of the Big 4 are likely to save their limited ammunition for bigger problems. These bigger problems could be a sharp slowdown in the eurozone, a no-deal Brexit or further escalation of trade tensions across the globe.

Keeping these factors in mind, what could be the expectations from the Big 4 in 2019?

• It would be a game of ammunition: To recall, among the four major central banks, the US Fed and the BOE were the only ones, which were able to restock their ammunition power by increasing interest rates in the last two-three years. Since 2015, the US Federal Reserve increased its policy rate from the lows of 0.25% to 2.50%. Similarly, the BOE increased its policy rate from historic lows of 0.25% to 0.75%. Whereas, the BOJ and the ECB could not move out of the ultra-loose monetary policies by increasing rates. As a result, the policy rate for the ECB, i.e. the Refi rate currently at 0.0% and that for the BOJ, the uncollateralized overnight call rate currently stands at -0.10%.
• US Fed would be the first one to move: Concerns over the impact from the trade war on already-slowing growth as well as weak inflation pressure have got Fed members increasingly concerned. Going by the futures market, it is widely expected that the US Federal Reserve will be cutting the policy rate by 25 bps next week. With a probability of 79%, a 25 bps reduction in Fed funds rate on 31st July is almost a done deal.
• The second round of QE in the Eurozone?  In its recently concluded monetary policy meeting, the ECB said that it was examining options, “such as the design of a tiered system for reserve remuneration, and options for the size and composition of potential new net asset purchases.” The current negative deposit rate in the Eurozone implies that banks have to pay the central bank in order to park their excess cash. The ECB could introduce a "tiered" system at its next meeting in September, wherein some deposits are charged differently or are exempted from paying the interest. It might also reintroduce a quantitative easing program in the coming months. This would be large-scale asset purchases of government bonds from eurozone countries in order to further boost lending and stoke inflation.
• What about the BOJ? In Japan, even as the current rate of inflation is running below the central bank’s target, the central bank seems to be reluctant to add to its already massive easing program unless absolutely necessary. Latest data indicate that because of the BOJ’s negative interest rate policy there is already a lot of pressure on bank profits. Profits for the credit unions and the megabanks fell in the fiscal year ended in March, according to a BOJ report last week. Therefore, when the BOJ meets next week for the monetary policy decision, it is widely expected to have a similar response as the ECB, highlighting that more easing could be on the cards and that it's looking into options.
• What about the BOE? Just last week, Mr. Haldane, the BOE’s Chief Economist, who also sits on the monetary policy committee, said that he “would be very cautious” about cutting rates “barring some sharp economic downturn”. It is believed that the BoE’s monetary policy decisions are likely to be premised on an orderly exit from the EU. BOE’s sensitivities around different outcomes of Brexit are likely to get clearer in its August inflation report (MPC meeting due on 1st August). Given the limited ammo that the BOE has, the central bank is unlikely to cut rates unless there is a sharp downturn in the economy.

How to ride the wave of easing?

• EUR vs. USD: In theory, as the US Fed is likely to move first towards monetary easing, it is the dollar which would be expected to depreciate against the rest of the major currencies. However, it must be noted that the US economy is likely to perform relatively better than the other DMs (Developed markets) on account of preemptive action by the Federal Reserve, that is rate cuts could lead to an early bottom-out for the US economy. Moreover, the US economic data remains mixed while headwinds to the Eurozone economy have risen (slowdown has become broad-based spreading to major economies like Germany and Italy, the chances of a no-deal Brexit have risen, risks from trade war). Therefore, it would be best, not to play by the book. An ideal strategy would be to bid for the dollar. With significant risks of a slowdown in the Eurozone, the pressure on the EUR could sustain in 2019. That is not to say that the EUR/USD pair would reach parity.
• DMs vs. EMs: The broad trend so far this year has been the flow of funds towards high yielding EM (Emerging markets) debt. This has augured well for the EM currencies, which have gained 2.3% on average so far this year. However, concerns about global growth have kept the appetite for the EM equities somewhat tight. As per the IIF data, even as USD 37.2 bn went into EM bonds in May and June, EM equities have seen an outflow of USD 2 bn. It is this risk of equity outflows that could negatively affect the EM currencies in the medium-term. If the global slowdown worsens and the risk of recession increases, the safe-haven trades could kick-off, and in such a scenario, the funds' flow could move back to the DMs. If this were to happen, the EM currencies could begin to depreciate. Moreover, most of the EM currencies (including the INR) are overvalued at the current levels and a correction is overdue. The trigger for such a phase could be a large downward revision in global growth estimates, a sudden escalation of trade tensions, or worries of a deep slowdown in China.