1 June 2018
“We are at a crossroads for extraordinary monetary policy. Much is misunderstood about the original purpose of QE, what impact it has had, and in turn, what impact its withdrawal is likely to have. These misperceptions exist right at the heart of our central banks, hence the risk of a major policy error cannot be ignored.”
– Neil Woodford
May was another positive month for UK equities in sterling terms, albeit increasingly volatile as the month progressed. In dollar terms, however, the UK stock market lost ground, with ‘greenback’ strength becoming an increasingly important feature of the market backdrop, in response to the deteriorating global liquidity conditions.
This is playing out most aggressively in emerging markets thus far, with steep declines in many South American and Asian stock markets and increasing signs of tension in foreign exchange markets.
Meanwhile, political events in Italy have brought the eurozone’s frailties back to the forefront of investors’ minds. With financial markets expecting a sustained economic recovery in Europe this year, political risk has not been appropriately priced, in our view, and this is another source of potential downside for the consensus.
The Bigger picture
Key Company Events
Thoughts on extraordinary monetary policy
Contrary to popular belief, QE made bond yields rise
Source: Bloomberg, MacroStrategy, Woodford
The original purpose of quantitative easing (QE), as defined by the US Federal Reserve, was to “push down interest rates”. In reality, however, the opposite occurred, as the chart illustrates. During every single period of QE, long-term interest rates rose – they did not decline. Over the entire period of extraordinary monetary policy, bond yields fell but this was as much to do with declining inflation and low growth as it was to do with the policy itself.
So, why did bond yields rise during every period of QE? The answer is, because QE is inherently inflationary (all else being equal). Importantly, this symmetry suggests that, as the policy goes into reverse, by implication, the Fed’s programme of Quantitative Tightening will increasingly exert deflationary pressure on the US economy.
We are already starting to see the impact of QT in global liquidity conditions. We believe central bankers should be paying more attention to the very close relationship between money supply and nominal GDP. Without this understanding, there is an increasing risk that central bankers in the US and Europe will make a significant policy error by withdrawing extraordinary monetary policy too soon or too fast, with obvious economic and market consequences.
More positively, there is one developed economy whose money supply growth outlook is not facing the impact of the withdrawal of extraordinary monetary policy. The UK economy has sustained nominal broad money supply growth of around 5% per annum recently – this, coupled with all the other positive trends in the UK economy that we have been highlighting, is enough to suggest that domestic growth can accelerate in the months ahead, leaving consensus expectations looking far too low.