Recent haemorrhaging in asset markets has significantly impacted global yield curves.
When we last discussed the US yield curve (September 26) markets were pricing in 3 x 25 basis points in rate hikes by the US Federal Reserve by end 2015 and a further 4x25 basis points in hikes in 2016. The first Fed hike was expected around April/May. That was in considerable contrast to the average of the 16 Federal Open Market Committee (FOMC) members who expected 6x25 basis points in hikes in 2015 and 6x25 basis points in hikes in 2016 (September FOMC minutes). We cautioned against taking that view too seriously rather pointing to the forecasts of the two that we labelled the “reasonable doves” who expected 1x25 basis points in 2015 and a further 5x25 basis points in 2016. We speculated that the “reasonable doves” may well be Chair Janet Yellen and Vice Chair William C Dudley Dudley.
Our own view has been for 2x25 basis points in hikes in 2015, with the first move not before September, to be followed by 6x25 basis points in 2016. That view on 2016 is predicated on US growth lifting sharply in 2016 to 3.25 per cent from 2.5 per cent in 2015.
Market pricing has now moved more into line with the “reasonable doves” with 2x25 basis points (first move in September) in 2015 and a further 3x25 basis points in 2016. We are comfortable with the 2015 scenario of the market but feel it is too downbeat on US growth prospects in 2016.
There have even been some calls for an extension of QE in the US. We doubt very much that the FOMC would give much credence to such a suggestion. There is already ample liquidity in the banking system with excess reserves held by the banks of around $US2.75 trillion ($A3.14tn) sitting on the Fed’s balance sheet. Reflecting the fact that banks have made little effort to put these excess reserves to work is the fact that the stock of bank loans is now lower than it was before the global financial crisis. Mortgage assets are down by around $US600 billion while business loans have only recently risen above the pre-GFC levels (Figure 1). As a result required reserves of the banks have only really increased because of tighter regulations rather than increased lending.
It seems reasonable for the Fed to take the attitude that because the key raison detre for QE – the stimulus to bank lending - has not eventuated it is time to terminate the policy. Markets should not be surprised that volatility has lifted as we move toward the completion of QE3. Such volatility surges followed the completion of QE1 and QE 2 (Figure 2). The US economy is stronger now than during those previous periods and even bank lending (to businesses) has started to lift. It seems a more prudent policy to stick with the tapering program for QE3 and rely on improved fundamentals to settle markets.
It also seems folly for US markets to rely on QE in Europe to stabilise markets. Mr Draghi’s plan to boost the ECB’s balance sheet by €1tn ($A1.46tn) is certainly ambitious – it compares with around €1.3tn from QE3 (based on average exchange rates). However the evidence of the last aggressive balance sheet expansion by the ECB (LTRO in 2011 and 2012) was that very little liquidity left the Euro region.
The turmoil in global financial markets has also impacted Australia’s yield curve. Markets are now pricing in a 50 per cent probability of a 25 basis point rate cut in Australia by September next year with only 1x25 basis point hike by end 2016.
That cut around the time of the first hike in the US seems highly unlikely. However, the market’s end 2016 scenario of RBA rate still at 2.5 per cent and Fed at 1.25 per cent is in line with the long term average margin between RBA and Fed of 1.5 per cent.
Readers will be aware of our own views that by end 2016 the RBA cash rate will be back at 4.0 per cent and the Fed at 2.25 per cent, back towards that 1.5 per cent margin. The key difference between market pricing and our own thinking is around the world economy and the US economy in particular.
We are expecting world growth to lift to 3.7 per cent in 2015 and to an above average 4.5 per cent in 2016. The key driver of that growth lift will be the US economy.
There has been a recent loss of momentum in the world economy. We have revised down our 2014 world growth forecast from 3.1 per cent to 2.9 per cent; the IMF has revised down their world growth forecast from 3.4 per cent to 3.3 per cent. Softer current momentum (along with the impending end to QE3) has been a key driver of global yield curves.
However much of this momentum loss has been due to an almost unprecedented run of “one-offs”: Japanese consumption tax; US weather in March quarter; Ukraine; and Ebola fears. It is dangerous, as markets currently appear to have done, to assume that there will be a series of new “one-offs” in 2015 and 2016.
Bill Evans is chief economist with Westpac.