How Far will Central Bank Stimulus Go?

Financial markets at the beginning of the coronavirus pandemic were shaped very differently. With global indices hitting all-time lows in the first quarter, investor sentiment has vastly improved as we head towards the end of quarter two and into the second half of 2020. The key question is; what has driven the financial markets and what do we expect as 2020 continues to unfold amid a backdrop of global economic uncertainty resulting from the coronavirus pandemic. Market indices such as the FTSE 100 returned 9% over Q2, with increasing optimism surrounding COVID-19 recovery, world markets overall surged by 18% over the second quarter indicating markets and the world economy could not be any less correlated with economic data at this present moment. However, one of the main driving forces has been the bountiful amounts of central bank stimulus, which has continued to support investor sentiment as we weather the coronavirus storm.

European Central Bank
The European Central Bank (ECB) reiterated a very muted response to fiscal stimulus in tackling Coronavirus towards the end of Q1, which led to a sell-off in financial markets. However, the ECB later went on to increase the Pandemic Emergency Purchase programme (PEPP) by a further 600 billion euros at the beginning of June, exceeding market expectations of a 500 billion euros increase, as a response to a downward revision in inflation, to a total of €1,350bn.

The lending environment in 2020 is very different to that during the financial crisis, with the global central banks overall supporting funding conditions in the real economy, which will aid recovery for businesses and households. The expectation is the PEPP programme will continue into mid-2021 and with interest rates remaining at low levels, markets have priced in optimism surrounding further central bank stimulus further into H2 2020.

Additionally, aid packages will strengthen the eurozone economy, which has seen signs of improvement. Previously, the ECB has been relatively vague with its policies and has previously underwhelmed markets, however, the announcement of its intent to reinvest principle payments from the PEPP until the end of 2022, will offer lasting support to periphery bond markets.

Bank of England
The Bank of England reviewed interest rates in Q1, reducing the base rate to 0.1%, which has remained its base rate throughout Q2 reiterating a slightly less dovish tone than other central banks. In addition, in its most recent June meeting, the monetary policy committee voted to maintain the stock of sterling non-financial investment grade corporate bond purchases at £10 billion and maintain the stock of UK government bond purchases at £435 billion.

Following the stimulus in June, purchases of government bonds will total £745 billion. The graph below indicates the quantitative easing levels since the financial crisis to support the UK economy, emphasising the influence quantitative easing has had over the years in aiding in UK economic recovery. The financial environment for central banks has drastically evolved since the financial crisis and therefore are poised to support the UK economy during unprecedented times, as we have seen during the coronavirus outbreak.

Quantitative easing graph

Although financial markets boasted a strong return in the second quarter of 2020, safe haven assets such as government debt has faced increasing demand amid a backdrop of cautious investment sentiment and poor economic data. UK guilts with a negative yield were traded for the first time in history during Q2, although this sparked a debate of negative rates with the Bank of England potentially following suit of the ECB, at this moment in time rates will remain as they are. Recent economic data has led to the MPC revising falls in GDP in Q2 to be around the 20% and not 25% as seen in the may report. As a result better performance is expected as lockdown starts to ease, and a more optimistic view may be reflected in stimulus movements moving forward. On the contrary, low inflation as we saw in May at 0.5%, may be a factor in revaluation in monetary and fiscal stimulus and therefore volatility in MPC policies will continue in the short-medium term, as economic data feeds through the UK economy.

Federal Reserve
Jerome Powell continued a dovish tone throughout Q2, with ongoing loses to monetary policy and no indication of raising rates in the short term. The fed categorized its actions to stabilise financial markets in four policy sub sectors, which includes:

• Quantitative easing (QE) asset purchases
• Liquidity and funding measures
• Credit facilities to directly support the flow of credit to businesses and consumers
• Temporary adjustments to bank regulations to enable banks to increase lending

In May, the Fed purchased $750 bn new corporate bonds and expanded to include BB- rated high yield debt in the primary market corporate credit facility (PMCCF) and $750 bn established the secondary market corporate credit facility (SMCCF) to purchase investment grade corporate bonds with 5yr and less maturity.

Since then, the FOMC reiterated rates will likely to remain pegged near zero until at least 2022 and with open-ended and flexible QE set to continue, with hints that the Fed is prepared to lend via its emergency facilities. Although the Fed remains cautious about the economic outlook, continuous loosening in financial conditions, we expect inflation and employment to remain below that of levels seen in Q4 2019 throughout 2021. With heightening downside risks including exacerbating China and US trade tensions and potential fallout from the upcoming US presidential election, the Fed is prepared to continue to pump stimulus into the US economy.

What’s next?
The expectation is that quantitative easing and looser monetary policy is set to continue well into the second half of 2020, moving into 2021. As poor economic data starts to feed through, materialising the true extent of the coronavirus impact on the global economy, central banks are prepared to implement measures which will weather the storm until global economies can survive the aftermath of the pandemic.

According to forecasts the dot plot median rate in the US should stay in its lower bound through to 2022, with little or no indication of an interest rate hike in the short to medium term. This should continue to support the US economy, with extended incentives for borrowing. Moreover, given the current pace of QE asset purchases of treasury securities and mortgage backed securities, a total of $1.3 trillion predicted in the second half of the year bringing the year-end total to $3.5 trillion. The bold policy actions by the Fed have been accommodative to promoting healthier financial conditions and we expect this to continue to support financial markets as we move further into 2021.

Other central banks across the globe continue to have a dovish stance and we expect this to continue moving into 2021. Baseline fiscal forecasts suggests ECB’s Pandemic Emergency Purchase Programme increased net purchases will suffice to soak up most of eurozone governments’ additional bond issuance until mid-2021, with expectations front-loaded sovereign bond purchases at a pace of about €150bn, slowing towards €50bn in Q2 2021. In a nutshell, stimulus is nowhere near ending and the ECB are positioned to support the real economy during the coronavirus pandemic. Moreover, reflecting on a downward revision medium term growth and inflation outlook, with core inflation at only 0.99% in 2022, extension of the PEPP remains likely.

With respect to the Bank of England, as a more hawkish sentiment in the previous monetary policy committee meeting in June, the likelihood of further monetary policy stimulus has slightly reduced, however still see asset purchases supporting demand in the gilt market. Moreover, although there has been noise surrounding negative rates, the policy meeting minutes showed no indication of negative rates. However, the MPC meeting on the 6th August will provide a full assessment of the possibility of bank rates being taken below zero, but with added downside pressures on bank profits with negative rates, we expect bank rates to remain as they are.

Amandeep Mandair
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