Markets question policymakers’ resolve

04 Sep 2019

An important development in recent months has been the rapid fall in market-based inflation expectations. This is partly linked to weaker growth prospects. But judging by the decoupling versus actual inflation, this also reflects market concerns over the ability and willingness of policymakers to boost inflation (expectations), especially in the eurozone. Furthermore, investors know that a looser fiscal policy is the right medicine, notably for the eurozone, but they are not fully convinced that it will be deployed effectively.

Exhibit 1 shows that the fall in long-term inflation expectations started earlier and has been more pronounced in the eurozone. More recently, however, US expectations have also fallen rapidly. This is a sign that markets are becoming more anxious about a more pronounced spill-over of the slump in manufacturing to the wider US economy.


Exhibit 1: Long-term inflation expectations have fallen by more, and more rapidly, in the eurozone than in the US


Source: Bloomberg and BNPP AM, as of 31/08/2019


Global monetary policy easing underway

Slower global growth and falling inflation expectations have set off a fresh round of monetary policy easing in various economies: the US Federal Reserve cut its policy rates by 25bp in July and the ECB has strongly hinted at an imminent package of measures. Fixed income markets had anticipated the growth worries since the start of the year, with both real yields and inflation expectations falling. The moves gained traction in August (Exhibit 2).


Exhibit 2: Fall in nominal yields driven by real yields, but also by lower inflation expectations


Source: Bloomberg and BNPP AM, as of 31/08/2019


A key question on investors’ minds is whether central banks are willing and able to support inflation expectations and tackle recession fears. We believe that the Fed can loosen policy further. Policy rates are at 2.0-2.25% and it could re-start quantitative easing (QE) if it wanted to. A willingness to act aggressively is less evident for now, but that is understandable given the resilience of the labour market and the wider economy so far.


Fiscal or monetary push?

It is a different story in the eurozone where the ECB has little monetary ammunition to support the economy as policy rates are already negative and legal constraints limit the scope for government bond purchases. Even if the will is there, the bond market is already questioning by its ability to act.

Most economists, investors and market observers know that an effective way to revive inflation expectations and support the economy is to expand fiscal policy. This boosts aggregate demand more directly and it helps to push interest rates higher.

This is what the eurozone desperately needs. Unfortunately, the scope for such a policy is only ample in northern Europe and in Germany in particular. Indeed, the German finance minister recently suggested that it could deploy EUR 50 billion if the slowdown morphed into a recession.

Markets are not fully convinced that even such stimulus would be a game changer for the economy or the German bond market which is already in scarce supply. However, these would be steps in the right direction. The freefall in yields in August stopped after these comments, but a material reversal is yet to be seen.