While 2013 should continue to be constructive for growth and inflation assets, G7 economies are still too vulnerable to be taken fully off their policy steroids. Talk of an imminent US ‘tapering off’ in quantitative easing (QE) is misplaced, as coming data will bear out.
However, even if it isn’t and tapering takes place, the most recent market reaction – the lurch in developed and emerging market bond yields, and sell-off in growth assets – still looks overdone. ‘Tapering’ is, after all, a further loosening in monetary conditions, albeit at a slower rate. This is akin to central banks continuing to throw out liquidity, only with a slightly smaller ‘bucket’. And, this in turn should mean that the main macro forces keeping core government bond yields low will stay in place.
First, economic recovery will remain only a two-speed process (three-speed if you include the BRIC economies) – with the ‘dollar bloc’ (US, Canada, Australia) outperforming Europe and Japan. In the G7, only the US, Germany and Canada have surpassed their pre-crisis GDP level.
Second, with the tool box empty, central banks will keep QE running – even though it’s been only partly successful. At the current rate of US job gains (a rolling three-month average of just 155,000), QE looks assured till 6.5% unemployment is reached in 11-12 months time. US QE could thus be extended through 2014 if unemployment falls become staggered.
The UK too may eventually do more. Our analysis suggests £330bn in extra liquidity is needed if Dr Carney wants to return policy to its extreme looseness of 2009 and 2011, when QE was last run. If all this comes via QE, which is unlikely, this would leave the BoE holding two-thirds of conventional gilts outstanding. In practice, though, this will come in tandem with the Funding for Lending Scheme. And, to establish anti-inflation credibility, Carney may hold off till later in the year.
Then there’s Japan. By planning to mop up the equivalent of twice net new annual JGB supply and encouraging outflows, this infers the nearest thing yet to ‘foreign currency QE’. This should impact globally.
The irony is QE’s being done least where it’s needed most – the eurozone. The ECB will ultimately capitulate, but first needs to smell deflation. Otherwise, with other central banks running it, the zone’s misery may be compounded by a stronger euro.
Fourth, three years of up-front fiscal correction is becoming as much a problem as the solution. By 2014, the US, eurozone and UK will each have lowered their deficits by 4-5% of GDP – the difference is the US is doing it more by growth. Meantime, with its own competiveness eroding, China will helpfully carry on supporting US Treasuries.
While QE looks like it is here to stay, the difficulty will be implementing exit strategies. This is uncharted territory. We have yet to see a fully independent central bank turn off QE. And, as we know from Japan, QE acts like a drug: the more you use it, the more you need it.
Neil Williams is chief economist for Hermes’ global government & inflation bonds
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