"First, do no harm." That command may, or may not have been part of the Hippocratic Oath among medical practitioners since ancient times. Central bankers, however, appear increasingly keen to follow that maxim on both sides of the Atlantic. On Wednesday, the U.S. Federal Reserve (Fed) once again lowered key rates by "only" 25 basis points to a target corridor of 1.75%-2.00%. And once again, its reasons included subdued inflation as well as risks resulting from weaker global growth and various trade conflicts, justifying another insurance cut. In that sense at least, President Trump has seems to have influenced central-bank policy.
The latest economic forecasts by central bankers barely moved. There was only a little more movement in the so-called "dot plot", in which Federal Open Market Committee (FOMC) members give their individual assessments of how key interest rates will develop in the medium term. On average, the central bankers are not currently signaling any further moves in interest rates in 2019 and 2020, at least according to their "dot plot". Ultimately, we interpret both the decision and the way it was communicated positively. This includes the fact that not all voting members of the FOMC agreed on the rate cut. Such diversity of views is exactly what you might expect of an independent central bank in uncertain times.
Unfortunately, monetary caution is not what markets have come to expect in recent years. This was also evident a week earlier, when the European Central Bank (ECB) unveiled its latest stimulus package. We took two important messages from the press conference of the outgoing ECB President Mario Draghi. First, it seems very likely that interest rates will remain extremely low for a very long time; the ECB has clearly moved back into crisis mode. Second, Eurozone monetary policy is now almost at the end of its tether and it seems to be largely up to fiscal policy to make up for any demand shortfalls. There are already some signs of this in France and the Netherlands.
The reasons for this are straight forward. The Eurozone economy has already been stuttering for several quarters. That partly reflects China's economic slowdown and the trade conflict between the United States and China. Moreover, Eurozone's inflation of 1% remains low. Even on its own inflation projections, the ECB looks set to miss its inflation target of "below, but close to 2%" for the foreseeable future.
Hence the need for new ECB measures. We believe the most important one is restarting the securities purchase program with a monthly volume of 20 billion euros from November 2019 onwards. The ECB intends to continue the purchases until shortly before an increase in key interest rates. The reinvestments even extend beyond the time of the first interest-rate hike. Second, the ECB has historically steered market expectations with its forward guidance regarding monetary policy. The key interest rates will most likely remain at the previous level or lower until the inflation rate converges "robustly" against a level close to the 2% target in the forecast period. Such convergence is also reflected in the underlying inflation trend. The ECB has thus raised the hurdle extremely high. We believe that even a temporary oil-price shock, which could catapult the inflation rate above the 2% mark, would not be sufficient if the core rate did not follow suit.
Since we do not expect inflation to rise quickly and sustainably, it appears that the ECB is cementing the low interest-rate level for years with this measure. In addition, the deposit rate was reduced by 10 basis points to -0.50% and a graduated system will be implemented. The last point in particular was long awaited. Northern European banks currently hold most of the ECB's surplus reserves. The ECB's current account currently holds 1335 billion euros, on which a "penalty interest" of -0.40% has been due so far.
Now the following applies: up to an amount of six times the minimum reserve (currently 131 billion euros), no penalty interest is due. Beyond that, -0.50% is charged on additional reserves deposited with the ECB. That means that almost 60% of reserves would probably be exempt from the penalty. According to the Federal Association of German Banks, the relief for the entire German banking system amounts to around 1 billion euros. We believe that it is not likely to solve the structural problems of the banking sector.
Last but not least, the conditions for the targeted longer-term refinancing operations (TLTROs) are also becoming even more favorable, as they are linked to the deposit rate and there are no surcharges. The last tender will be allocated in 2021 and will provide banks with liquidity until 2024. The main beneficiaries should be southern European banks, which should use this time to further reduce their portfolio of non-performing loans.
All of which raises the question how effective the program will be. The problem is that neither the Fed nor the ECB can undo the consequences inflicted by U.S. trade policies on the global economy so far. All they can do is provide extremely favorable financing conditions to further stabilize domestic demand. Both packages can be seen as a kind of insurance against increasing economic downside risks. However, entering a very long phase of extremely low interest-rate policy entails considerable risks for financial stability (including the potential for price bubbles in the real-estate market, private pension systems).
These side effects are becoming ever more evident in the Eurozone. Even Christine Lagarde, the new ECB President, has stressed as much in her hearing before the European Union (EU) Parliament. Under Lagarde, the ECB still looks set to continue very loose monetary policies, but will probably be more mindful of the negative side effects. We think that it will try to take further corrective measures, such as the tiering system now being introduced. Unfortunately, such measures are likely to only mitigate the consequences of the low-interest policies, and may well also have further unintended knock-on effects.
For an illustration, look no further than the stunning developments which interest rates had on the U.S. refinancing markets and on short-term liquidity in the days leading up to Wednesday’s Fed meeting. Interest rates for short-term money jumped sharply. A number of reasons were cited by traders, some of them quite nervous. The Fed itself was surprised, even as it claimed that such developments would have no implications for monetary policy. More liquidity has already been and should be provided in the future. The decision to lower the overnight deposit rate more than the usual 25 basis points to 1.80% from 2.10% was purely technical, Powell tried to reassure viewers of his press conference. Whether the markets will follow this assessment remains to be seen. And with both sets of measures largely in line with our expectations, we do not consider them a sufficient reason to change any of our main asset class convictions, which are:
Fixed Income: The recent announcements fit with our strategic view that interest rates are likely to remain low for longer. We would not put too much weight on initial market reactions (most bond yields increased) after the decisions. We still expect the most important government-bond yields to trade sideways in the medium term. From a tactical perspective, we are now neutral on Bunds and prefer longer-dated to shorter-dated U.S. Treasuries.
Currencies: With regard to the euro-dollar currency pair, the two central-bank decisions have provided little new information and have thus not given the currencies any new direction. For now, currency markets are likely to focus less on central-bank policy and more on geopolitics and economic developments. We continue to expect sideways movement with a slight upward trend for the euro over the next 12 months, which should be reflected in an exchange rate of 1.15 dollars per euro.
Equities: For the equity markets the decisions, tough not unexpected, are a double-edged sword. On the one hand, the stock markets continue to be supported by the fact that bond markets are likely to generate consistently lower yields. On the other hand, central banks do not operate independently of macroeconomic data. In addition, we assume that the financial sector should continue to be burdened by the interest-rate environment. This is particularly the case in Europe due to the negative interest rates. In general, we doubt that the recently announced ECB package will be welcomed as a whole by European business leaders. We do not expect lower rates to stimulate the economy, so therefore we believe there is no reason to adjust the 2020 earnings estimates upwards. We rather assume that consensus estimates will have to be revised downwards. However, we forecast earnings growth of 5% in 2020. Together with a dividend yield that is significantly higher than short-term interest rates, this should help to make equities attractive. Nonetheless, the implicit economic worries of the central banks are also a concern for equity markets. Valuations of most equity markets are currently higher than in previous late-cyclical phases. The low interest-rate environment is now leading to a valuation discrepancy between value stocks on the one hand and growth and defensive stocks on the other that has surpassed previous record levels. We do not expect this valuation premium to disappear in the short term, especially as we do not see any significant increases in interest rates.