Monetary policy: the dawn of a new era?

After 10 years of loose monetary policy, 2018 has been a turning point. A new era is dawning and is disrupting financial markets. Following a period of massive expansion, major central bank balance sheets are now stabilising. The recalibration of the European Central Bank’s (ECB) Asset Purchase Programme to EUR 30 billion per month and the reduction in the Federal Reserve’s (Fed) balance sheet mark the start of a withdrawal of liquidity facilities. With the Fed having tightened its base rates by 0.25% for the ninth time in a row from December 2015 onwards, while the ECB is now on the point of suspending its purchase programme, financial conditions have deteriorated and clouds are gathering over the global economy. Winding down quantitative easing is proving to be a perilous exercise.

Skilful communications from the central banks will undoubtedly accompany monetary normalisation. After promising to refrain from raising rates before summer 2019 and to continue investing the interest from its assets for “as long as necessary”, what does Mario Draghi have in store for us before he stands down? He is very likely to express his support for the banking sector, which can survive only in an environment characterised by higher monetary rates and low financing costs. We are therefore inclined to believe that targeted longer-term refinancing operations (TLTRO) will be extended into the first half of the year and there will be an initial hike in the deposit rate during the second half. On the other side of the Atlantic, the Fed under Jerome Powell is likely to adopt a more pragmatic approach based on economic indicators. Two more rate hikes are expected in 2019 notably due to wage tensions triggered by low unemployment. Although the gap between the yield curve in the US and Europe will therefore remain wide, it should nonetheless narrow progressively, initially among longer-term maturities.

The performance returned by fixed-income assets will not remain unscathed by monetary normalisation. On the one hand, there will be less demand for bond securities and on the other, supply will increase. Public deficit funding and the debt maturity wall will increase issue supply while central bank purchase programmes will have been significantly tapered. These factors will lead to higher volatility notably among corporate bonds and will also incur a liquidity risk. Among bank debt, the TLTRO expiry should generate EUR 200 billion financing requirements in secured and senior formats. The announcement of an extension of the TLTRO by the ECB will breathe fresh life into European bank funding, notably in Italy.

Lastly, 2019 will be marked more by a return to fundamentals, rather than heightened volatility. When a monetary tidal wave hits the shore, it sweeps away everything in its path. Unfortunately, it is only once the tide goes out that the damage becomes visible. A more discerning investment approach has therefore made a comeback, providing excellent investment opportunities, while credit spreads have already returned to more attractive levels. Selectivity and flexibility are the keywords of our fixed-income investment strategy which will enable you to arrive safely in port in 2019.