Talk of monetary policy normalisation has been gaining momentum over the last six months. There are two different aspects to it: higher interest rates, and balance sheet tapering. The move towards them is gathering pace because the global economy has held up; volatility has been extremely low since Q1 2016 and risk assets have performed strongly. Last week the Bank of England finally pulled the trigger with a 25bps hike in the base rate. But I would argue we are still a long way from ‘normal’.
Anyone expecting a rapid return to interest rate normalisation in the UK is sadly mistaken. Forward-looking indicators do not suggest the economy is running at full throttle or even above trend. Next year, inflation will trend down, the consumer will be challenged, and uncertainty over Brexit and trade will stymie investment.
Because of this, I would be very surprised to see a rate rise in 2018. The European Central Bank, meanwhile, has made it clear that there will be a prolonged period between the end of its asset purchase programme (which is forecast to be at the end of 2018) and the first rate hike. All this tells us that the ‘normalisation’ of rates will be a very gradual process.
Inflated balance sheets
There is a staggering $20 trillion (£15 trillion) sitting on central bank balance sheets globally. The Federal Reserve holds 23% of the government bond market, while the Bank of England holds 22%. The ECB is talking about normalisation while it is still buying €30 billion (£26.3 billion) in bonds every month from January next year. Although the BoE has stopped buying, its balance sheet is huge, and the Fed has stopped reinvesting the proceeds of bonds, but it has not started selling the bonds it owns.
The road to normalisation could take a decade to travel. Why so long? There are structural issues to contend with: high levels of global debt which make the economy vulnerable to rate rises, demographic challenges slowing down the labour market, and the lack of sustainable, above-trend growth.
Impact on fixed income
There is a narrative that policy normalisation will be bad for fixed income, but we think the fallout may be as unconventional as the policy itself. All risk assets have benefited from QE and, as that is withdrawn, all are vulnerable. Our base case is for a knee-jerk fall in fixed income, followed by a flight to quality back into bonds as other assets start to suffer. Investors should lock down beta strategies and focus on quality alpha strategies. Now is not the time to move down the risk spectrum. Instead, use this opportunity to build a portfolio which can ride out volatility should it occur.