A revised approach to monetary policy: Macquarie’s insights

Market insights

Peter Rawson-Harris, Research Analyst, Macquarie
Wednesday 17 August 2016

Economic and market highlights

Newsflow in July fed expectations of prolonged accommodative monetary policy, with major central banks acting in concert to buoy investor and business confidence in the face of a wave of uncertainty emanating from the UK following the Brexit vote.

On this occasion, this did not involve major changes to policy rates or asset purchase programs as has been common in the past, with central banks choosing their response more carefully – using only words – as scope for monetary policy to effect change diminishes with interest rates in many developed economies at or near zero.

The attention of investors and traders has moved on from the outcome of the Brexit vote to the potential policy solutions with central banks back in the driver’s seat. This is producing a liquidity-driven risk-on rally as investors celebrate easy monetary policy for the foreseeable future, despite weak corporate profit growth and negative sentiment. Fiscal policy, true to the long-established precedent, is conspicuously absent from much of the debate.

The S&P/ASX 200 added 6.3% in July, the largest monthly increase since February 2015, with all sectors positive. International equities were also strong.

The S&P500 added 3.6% for the month to reach record highs, while broad MSCI indices for developed and emerging markets rallied 4% and 3.9% respectively.

The deterioration in the British pound paused, with the currency losing only 0.7% against the US dollar, while the UK’s FTSE 100 lifted 3.4% on a weaker currency and monetary stimulus expectations.

Since the vote, UK equities have gained 8% and the pound has lost over 10%, which has seen returns to unhedged investors going backwards.

In Continental Europe, after a generally poor showing last month, there has been a moderate bounce with Germany’s DAX and France’s CAC40 returning to levels of late May, although this is unlikely to follow US markets higher in light of Europe’s financial sector woes, negligible earnings momentum and no recent extensions to asset purchase programs. The European periphery markets still lag due to concerns around economic growth, poorly capitalised banks, and politics, though the situation is improving. An increase in European terrorist activity also weighed.


Given the tepid inflation, subdued growth in labour costs and persistent strength of the Australian dollar, the Reserve Bank of Australia chose to cut interest rates by 25 basis points in July. This takes the official cash rate to 1.5%. Markets are expecting further cuts, pricing in a 50% chance of another by November. The scope for further rates cuts is diminishing. Each successive interest rate reduction produces only a fractional change in borrowing rates for consumers as banks attempt to preserve net interest margins.

Persistently low inflation and subdued wage growth give the RBA scope to cut rates

Source: Source: MWM Research, FactSet, August 2016

United Kingdom

The Conservative Party in the United Kingdom elected Theresa May as Prime Minister, whose position in relation to the recent referendum is, “Brexit means Brexit”. While there had been much discussion of another vote on EU membership, this is now highly improbable.

The Bank of England (BoE) has acted decisively in the rapid deterioration in business conditions and the potential for weak near-term demand to produce an increase in unemployment. Data from recent surveys of confidence and business conditions, for example the Purchasing Managers Index, were consistent with the weak outlook.

UK business activity has dipped in the wake of Brexit

Source: MWM Research, FactSet, August 2016

The policy response from the BoE was a 25 basis point cut in the bank rate to 0.25% - its lowest level in the bank’s three century existence – and an extension of the UK’s asset purchase program “Term Funding Scheme” (TFS) by £60b of government bonds and £10b in corporate bonds, an outcome which was towards the upper end of market expectations.

The expansion of the TFS will act to lower yields on securities which are used to price borrowing rates for households and businesses. It also has the effect of pushing portfolio rebalancing as investors seek to maintain returns by moving into riskier assets, like corporate bonds, which boosts the supply of credit in the economy.

Governor of the BoE, Mark Carney, is one of the few central bankers who still adheres to the belief in a zero lower bound for interest rates. This view is reflected in the central bank’s Monetary Policy Summary, in which it states that the bound is “close to, but a little above, zero”.

This is a marked difference from central banks of Europe and Japan, many of which now use various forms of negative policy rates. The BoE’s mix of monetary policy measures are designed to ensure transmission of more accommodative policy to households and businesses, which becomes challenging when banks cannot find anyone to lend to (of sufficient creditworthiness).


The European Central Bank meeting in July produced no further changes to interest rate policy or asset purchase programmes. Stress tests run by the European Bank Authority revealed few surprises, with most banks improving since a similar test in 2014.

Solvency is a fading concern, with the exception of Banca Monte dei Paschi, Italy’s oldest bank which has been plagued by nonperforming loans. However, over the course of the year, European banks have lost about a quarter of their market value but the worst of it has likely passed.

The reaction in bank debt and credit default swap markets has been quite measured, suggesting fixed income investors are pricing in a relatively benign outcome.

United States

In the US, a dismal May jobs report has been followed by the two strongest results this year with June and July nonfarm payrolls both over 250,000. This continues to be a challenge for policymakers as output growth is unable to match the strength in the labour market. This implies a persistent slowing in productivity growth. However, its impact on wages growth, inflation more generally, and the path of interest rates, will likely be of more immediate concern. Macquarie’s US economist base case for the next move in the Federal Funds rate is December.


The Bank of Japan (BoJ) is facing a crisis of credibility. At its recent monetary policy meeting, the BoJ failed to impress markets with its decision to leave interest rates and asset purchases at current levels.

The only change was a slight tweaking of Exchange Traded Fund purchases from ¥3.3t to ¥6.0t per annum, which is a very modest increase in light of existing Japanese government bond (JGBs) purchases of ¥80t a year.

This led to fears that maybe the central bank has run out of fire power, and caused investors to dump JGBs in dramatic fashion. With headline inflation back in negative territory and core inflation positive but declining, it will be some time before the BoJ is able to hit its 2% inflation target.

The reaction in currency and interest rate markets was swift and implied a considerable divergence between expectations of additional policy accommodation and reality. Yields on 10 year Japanese Government Bonds (JGBs) made their largest one-day move in absolute terms since January, rallying 10 basis points, while the yen strengthened over 2%. Yields continued to rally in the ensuing days, gaining 25 basis points to sit just below zero.

It is possible that the past month has seen an all-time low in JGB yields.

For years, a bull market in JGBs has persisted, as investors have bet on intractable disinflation and deflation producing lower and lower interest rates in Japan, which in turn have driven the price of JGBs higher and higher.

The last month has shown how vulnerable Japan’s bond market, and by extension global bond indices, are to even a slight adjustment in expectations for further monetary policy accommodation.

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