Reversing the 'great easing': what lies ahead for central banks

Estimates for 2022 world growth continue to be buoyant, with the International Monetary Fund (IMF) forecasting 4.9% and the Organisation for Economic Co-operation and Development (OECD) forecasting 4.0%, strong growth in the wake of 2021’s likely near 6.0% pace (a 40-year high).

Strong growth ahead, but policy becoming ‘less easy’

It is with that backdrop that the period ahead is going to be one where policy turns less stimulatory.

Markets are likely to focus less on the tightening of fiscal policy. But 2022 is, nonetheless, a year where the fiscal impulse turns from a tailwind to a headwind, as governments globally begin the long, likely multi-decade, journey of repairing their balance sheets. According to UBS, after a record-breaking 4.0% (of global output) fiscal stimulus in 2020, an insignificant -0.3% fiscal headwind in 2021 becomes -2.4% headwind in 2022.

Three factors probably mitigate this impact:

1. Most of the adjustment is in the US and it’s largely timing. The front-loading of income support in first-quarter 2021 means the recorded 2022 impact is actually unfolding in second-half 2021. Outside the US, 2022’s global fiscal drag is more like 1%.
   
2. Less pandemic income support for many will largely be offset by high saving balances.
   
3. Fiscal sentiment is likely to be buoyed by new US infrastructure packages from 2022 before end-year. An expected first-half 2022 federal election in Australia is also likely to underpin additional fiscal support domestically.
   

Markets will intently focus on the tightening of monetary policy — in particular, the outlook through 2022 for the removal of quantitative easing (mostly bond buying) and any actual increase of central bank policy rates. As always, the path of inflation will be key in determining the urgency with which central banks respond. Here, recent data supports banks’ views that near-term inflation is being elevated by short-term supply-chain pressures (and base effects) and a structural inflation uplift is not immediately upon us.

Moreover, central banks have a strong incentive not to prematurely derail the recovery. Many central banks — including the US Federal Reserve (Fed) and Reserve Bank of Australia (RBA) — have openly shifted their reaction function from pre-emptive to re-active. In other words, they have committed to not lift rates until inflation is sustainably within their target ranges. As discussed below, this is leading to significant global phasing of policy moves.

Further, many central banks — including the RBA and European Central Bank (ECB) — are acutely aware they have underperformed their inflation target for the past five to 10 years and would likely be keen not to repeat the outcome, giving them scope to be slower than normal to respond. Their colleagues on fiscal policy are also likely to prefer moderate (rather than low) inflation to boost wages and company revenues and aid the repair of budget positions.

Who are the hawks? Who are the doves?

The Fed is widely viewed as the global setter of interest rates. And like the Fed, most developed economy central banks have rates set close to zero. Looking ahead, the Fed is surrounded by some central banks that are more hawkish, as well as some that are more dovish. See the table below.

• The Bank of Canada, one of the first banks to announce tapering in April 2021, is expected to signal further tapering at its October meeting, cutting its bond-buying from $2 billion to $1 billion per week. It is widely expected to finish this year. However, Governor Tiff Macklem, like Fed Chair Powell, has emphasised that the end of bond-buying and the start of the hiking cycle are two separate decisions. UBS expects the Bank of Canada to start hiking from July 2022, while CBA forecasts fourth-quarter 2022. 
• The Bank of England, at its September meeting, kept the policy rate unchanged at 0.1%. But according to UBS, “the BoE appears to have turned more hawkish”, with two dissenters voting for reduced bond buying (currently GBP 3.4 billion per week). Indeed, the Bank of England's bond program (GBP 875 billion in total) has already been tapered and is expected to be complete before end-year. The bank also noted the case for modest tightening over the medium term had been strengthened. Both UBS and Société Générale see the first interest rate hike mid-2022.
  
• The Reserve Bank of New Zealand is widely seen as the next most likely to follow the Norges Bank, despite having also whipped the market into a frenzy with speculation of negative rates at the height of the pandemic. Markets are priced for a 0.25% hike on 6 October (to 0.50%) and UBS sees rates rising to 1.5% by August 2022, with further 0.25% hikes every quarter from here.

The outlook for bonds and currencies

Latest estimates suggest global central banks are moving slowly, not inconsistent with their recent rhetoric regarding taking a more reactive, rather than pre-emptive, approach to inflation. Indeed, while there are a few key developed market central banks likely to begin lifting rates during 2022 (the hawks, namely the Bank of England, Bank of Canada and Reserve Bank of New Zealand) from a starting point near-zero in 2021, policy rates on average seem unlikely to exceed 1% before 2024.

Of course, while policy interest rates are likely to remain very low, most central banks are positioning or have already begun to wind back their stimulus via bond-buying during the next 12 months. The impact of this on bond yields is uncertain. On the one hand, the improved growth outlook should lead to higher bond yields. However, on the other, in 2013, concerns central banks were moving too quickly saw bond yields retrace lower.

On this outlook, monetary policy remains historically accommodative for an extended period of time. This is likely to underpin both economic and asset price growth in the next couple of years and provide a very supportive backdrop for risk assets, particularly housing and equity prices.

Such an outlook is likely to continue to see unemployment rates fall over time, potentially to levels that should lift wages growth and eventually inflation (potentially through 2023-24). And if central banks have the courage to hold firm to their promise to hold fire until inflation is sustainably above target, inflation expectations and longer-term bond yields are likely to continue to grind higher (and curves trend steeper) in the period ahead.

This environment is one consistent with positioning portfolios moderately overweight equities relative to fixed income, while continuing to build exposure in unlisted (including defensive) alternative assets that are likely to be impacted less if inflation proves a challenge for risk appetite in the future.

Recent weeks have seen the accumulation of central bank tapering news — and the potential earlier-than-expected timing for the first Fed rate hike — push US 10-year bond yields from 1.30% to 1.51% in September. Ten-year yields have risen from 0.59% to 1.02% in the UK and -0.42% to -0.20% in Europe over the same period.

We continue to expect 10-year bond yields in the US and Australia to drift higher to a 2.0%-2.5% range in first-half 2022. Thereafter, the balance between bond demand and supply will be important to the future direction as central banks purchase less, but fiscal issuance reduces as budgets trend better post-stimulus. The balance between longer-term disinflationary forces such as demographics and tech disruption, and inflationary forces such as wages growth and ongoing supply-chain rigidities will also be important.

For exchange rates, the clear delineation between central banks that are relatively hawkish and dovish over the coming year suggests the Australian dollar, the euro and the Japanese yen may struggle relative to the UK pound, New Zealand dollar and Canadian dollar.

For the Australian dollar, UBS and CBA target about US$0.80 for end-2022, a 10% rise from here. This is likely to see the domestic currency outperform the euro and the Japanese yen, but less so the British pound, which could rise even faster. That said, we believe recent developments in China suggest risks are skewed to the downside for the Australian dollar.

Learn what Crestone can do for your portfolio

With access to an unrivalled network of strategic partners and specialist investment managers, Crestone Wealth Management offers one of the most comprehensive and global product and service offerings in Australian wealth management. Click 'CONTACT' below to find out more.