After seven years of interest rate cuts and trillions of dollars in quantitative easing, discussion is growing over whether monetary policy is losing its effectiveness, given the growth outlook for advanced economies remains below 2%.
These measures have fallen short of stoking inflation to the degree major central banks had hoped, leaving economic growth sluggish and the macroeconomic backdrop somewhat mixed across regions.
However, the news is not all negative. Investment-grade corporate bonds generally do well where growth is subdued – whereby there is no anticipated deflation, nor runaway inflation as growth accelerates too strongly. So, that this may be seen as the proverbial sweet spot for investment-grade bonds (notably in the US), where economic growth of a subdued range of 1% to 3% is a general rule of thumb. US annualised economic growth is at about 1.2%.
In addition, the quantitative easing (QE) programs underway in Japan, Europe and the UK support corporate bonds as central banks buy up sovereign and corporate debt, as well as other risky assets (in the case of Japan) to spur inflation and, ultimately economic growth.
The Bank of England (BOE) recently began buying sterling-denominated corporate bonds as part of a plan to buy £10bn (US$13bn) worth of investment-grade corporate debt over 18 months3. In July, European Central Bank (ECB) President Mario Draghi confirmed the ECB would continue monthly asset purchase of €80bn (US$89bn) a month until the end of March 20171.
Meanwhile, the QE implemented by the ECB and the BOE are having a spillover effect, steering money into other regions where valuations are more attractive. This flow is evident in the US market. Foreign demand for US dollar assets has increased this year due in part to the QE-related flow of money, and central banks are expected to continue to drive that.
The US and Australia still have room to move
From a corporate bond perspective, investment-grade corporate bonds in the Australian and US markets are AMP Capital’s preferred areas of investment.
One reason for our positive view of US and Australian investment-grade corporate bonds is valuations within those two markets are slightly more supportive than those in the European market. In Europe, valuations offer less additional compensation outside of the enormous support that the central banks have already put into the market through QE.
In terms of Australia when you look at policy flexibility, Australia has got more flexibility, however ultimately a lower exchange rate may be needed as part of the effectiveness as monetary policy considerations and messaging occur.
From an interest rate perspective, where a higher relative cash rate and reasonably steep yield curves than those of other economies suggest the RBA can cut rates further if need be. There may be one further interest rate cut and if certain economic data, such as business investment and inflation, continue to disappoint, the RBA certainly has the currency and rate flexibility to continue to move.
Final thoughts
As central banks discuss, often publicly, whether more emphasis should be placed on fiscal policy to stimulate inflation from benign levels, uncertainty over the timing of a transition phase may give rise to greater volatility across asset classes.
We believe any shift away from monetary policy towards other stimulatory measures, such as fiscal policy, will be gradual. However, in the meantime, we are watching currency and rates markets closely for signs of disorderly adjustment to the next phase of the Federal Reserve’s planned policy-tightening cycle and other signs of central bank transition.
We see this as an opportunity to add risk due to underlying policy support, other broader macroeconomic data trends and valuation adjustments.
Article by David Carruthers, Head of Credit and Core, AMP Capital
1 European Central Bank, Introductory Statement to the press conference, 21 July 2016 https://www.ecb.europa.eu/press/pressconf/2016/html/is160721.en.html
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