Central Banks: Unprecedented reactions in extraordinary times

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The reaction of central banks across the world to the impact of the coronavirus has been exceptionally quick and large. Significant purchase programs have been set-up to purchase the supply of new government bonds and to keep lending rates for corporates and households low. Central banks have also implemented extensive and cheap lending programs for banks, so that they remain able to support the real economy. Alongside these "bailouts", rates have been cut to all-time low levels and appear to remain there or lower for the foreseeable future.

Central Bank balance sheets ($bln)

Figure: Historical and projected size of central bank balance sheets
Source: Bloomberg, Aegon Asset Management

US Federal Reserve: Quick reaction with multifaceted easing

Covid-19 containment efforts shut down a wide swath of the US economy in March and April, prompting an aggressive response from the Federal Open Market Committee (FOMC). The FOMC cut rates to near zero, announced unlimited quantitative easing (QE), and in conjunction with the US Treasury, announced several asset purchase programs designed to support various segments of the credit market. Furthermore, at their last meeting, the FOMC indicated in their "dot-plot" of individual committee members' expectations for future rates, to keep rates at this current near-zero level at least through 2022. Federal Reserve (Fed) Chairman Powell was widely quoted in his subsequent press conference as saying, "We're not thinking about raising rates. We're not even thinking about thinking about raising rates."

Fortunately, the Fed's actions have had their intended effect. The precipitous decline in equities has reversed, fixed-income markets are functioning normally again and credit spreads have compressed dramatically. In response, the FOMC reduced their pace of QE purchases, and many of the market-driven Treasury/Fed programs have had little uptake to date.

Nevertheless, the FOMC's actions are not a panacea. They were simply a response to the sharp contraction in the US economy and tightening of financial conditions. Ultimately, the FOMC's next steps will be a function of further economic developments and market reactions, which in-turn, are a function of how the US responds to the coronavirus situation.

The FOMC would be willing to do more if the US economy worsens, or if financial conditions experience a sudden re-tightening."

What more could and would the FOMC do?

Over the last month or so, many states have been opening their economies back up, which has provided some level of optimism for the potential of future growth. However, given a Covid-19 vaccine is unlikely to be available until next year (at the earliest), the virus will remain a headwind to the US economy for quite a while. Even more troubling, the rate of those testing positive is increasing, and hospital resources in some southern states are beginning to become stressed. This represents a significant negative development, and is one that could prevent a V-shaped recovery the market appears to be pricing-in.

While the FOMC's current stance is certainly appropriate, it's also clear they would be willing to do more if the US economy worsens, or if financial conditions experience a sudden re-tightening. More than likely, this would be implemented as additional QE purchases and extensions or expansions of their joint Treasury/FOMC programs. Another possibility would be the introduction of yield-curve control, whereby the FOMC essentially strengthens forward guidance by setting a yield cap on front-end Treasuries (buying at yields above that cap). We believe it would take a significant worsening of economic conditions and/or market volatility for the FOMC to implement any yield caps. Similarly, it's possible the FOMC could cut rates to a negative level, but we think that the FOMC is keenly aware of the exit problems negative rates represent, and would only embark on such a strategy if things get much, much worse.

European Central Bank: Supporting bank lending and controlling peripheral spreads

To date, the European Central Bank (ECB) has proactively battled any risk of market fragmentation, both in the sovereign and the financial side. It has shown a strong commitment to act whenever volatility appears and to do so quickly. The actual combination of very low rates, extensive purchasing programs and a variety of other measures have been designed to address the different challenges that European economies face as a consequence of the pandemic and its economic fall-out. In the context of a region with different fiscal stances and long-term economic objectives, the ECB has proven to be a reliable source of stability and European bond markets have certainly appreciated that.

With periphery spreads under relative control, the question remains whether the ECB alone can do enough to contain yields given the massive issuance that is expected to occur during the next 12 months. If a second wave of Covid-19 forces new lockdowns across countries, this may require measures that cause deficits to surge even further. For this reason, the negotiations on an extensive European recovery fund will be key. However, concerns over the lack of conditionality on funds granted and the shadow of debt mutualisation is stalling negotiations at a political level, leaving the ECB as the main anchor for interest rates. We expect the ECB to act more aggressively if negotiations last for too long or if they fail.

The question remains whether the ECB alone can do enough to contain yields given the massive issuance that is expected to occur during the next 12 months."

At the beginning of July, the question raised by the German Constitutional Court on the adequacy of the measures taken from 2015 until 2019 was finally cleared, as both the parliament and the Bundesbank considered it proportionate to the situation. This scrutiny will, however, force the ECB to be extra careful and act within the constraints of its mandate in the future. In January 2020, Christine Lagarde announced that a strategic review would take place to assess the role of the ECB. This exercise seems now more needed than ever in the context of the pandemic, especially because the range of measures taken before the pandemic did not consistently align inflation closer to the 2% target.

Bank of England: Enabling credit to flow to the real economy

The reaction of the Bank of England (BoE) to the Covid-19 pandemic so far has been one of rapid and aggressive quantitative easing with a specific purpose.

The BoE quickly cut rates to 0.10%, which they view as the absolute lower limit. A QE program was also enacted quickly in March when gilt yields were rising dramatically or "dislocating" in Central Bank parlance. The QE program was only increased to the point that it matched the extra gilt issuance arising from the government's fiscal response to fight the economic consequences of the pandemic. The BoE also enacted a number of new programs to help credit flow through to the real economy, with a host of new acronyms; TFSME, CCFF, CTRF.*

The QE program has been allowed to continue until the end of 2020, which means that the pace of buying on a weekly basis will drop from current levels. This is reflective of the BoE's need to be less dominant in the gilt market as the UK government's borrowing needs decrease. As long as a recovery takes place, we think the BoE will not announce any more policy actions this year.

A longer-term consequence is the relationship between the BoE and the government. The way they have worked together in these unprecedented times so far has been impressive, monetary policy is clearly aligned with fiscal support. It is a powerful combination, being able to fund massive budget deficits at little cost. The longer this policy continues, the more "normal" it may become.

As long as a recovery takes place, we think the BoE will not announce any more policy actions this year."

Central banks; Full throttle at the lower limit

The Covid-19 crisis was one of central bank superlatives. The interventions were absolutely needed to ensure proper financial market functioning and to soften the blow to the real economy. Central banks are likely to increase their programs further into the second half of this year, especially if a rise in infections would induce further economic damage. Central banks are unfortunately not able to offset the severe hit to the economy, the only think they can do is to limit the damage being done.

The sharp rise in government debt and the increase in central bank programs, will imply that the developed world will likely experience very low or negative interest rates for the foreseeable future.

*TFSME: Term Funding Scheme with additional incentives for SME's; CCFF: Covid Corporate Financing Facility; CTRF: Contingent Term Repo Facility.

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