Macro-prudential policies & the Great Moderation 2.0

Macro-economic volatility has decreased substantially from the mid 80s onwards in a large number of economies. This period of reduced macro volatility was termed the Great Moderation. However, during the financial crisis GDP growth plummeted and inflation evaporated just to rebound thereafter amid massive fiscal and monetary easing. This lead macro volatility higher and stopped the talk of the Great Moderation. However, as of late volatility in a large number of economic data – most notably growth and inflation – has decreased again. This is shown in the chart below for US real GDP growth. There are a number of reasons for a more stable growth development, most notably that modern economies are far less dependent on the very cyclical and volatile manufacturing sectors but more dependent on less cyclical and less correlated services sectors (for example, education and healthcare). Moreover, inventory management has also been a key factor in determining macro-economic volatility. During good times, manufacturers and retailers increase their inventories, thereby leading to even higher growth. During bad times, though, they want to reduce inventories and as a result, production needs to be decreased by more than demand has fallen, aggravating the downturn. Nowadays, however, more manufacturers use just-in-time management methods and are used to lean inventories. As a result, this also reduces macro-economic volatility (and again services are less volatile as services can not be stored and hence there is no inventory problem). Additionally, the state has a larger role within the economy than during previous periods and tends to act as an economic stabiliser. Finally, the monetary policy enviornment has changed as central banks increasingly focused on providing for a stable enviornment via the adoption of inflation targets. As central banks have become more credible in securing a low inflation environment, inflation expectations and therefore also inflation has become more stable (and inflation tends to be more stable at low levels anyhow).  

US GDP and rolling standard deviation: increased stability after the Financial Crisis 

Source: Bloomberg, ResearchAhead

These factors are all still in existence and hence this should be seen as the main reason why the environment of low macro-economic volatility has re-established itself. What is more though, nowadays there is one additional element at play as a means to prevent another financial crisis: the increased usage of macro-prudential policies. The aim of such policies is to manage systemic risks within the banking sector as well as the broader economy. It thereby should lower the probability of another devastating financial crisis. Mostly, it is expected to do this via preventing the build-up of new excesses in certain regions or sectors. As an example, facing a credit-fuelled house price surge, the macro-prudential regulator would for example demand higher capital buffers or reduce the maximum allowed loan-to-value ratio. This should ease rampant credit growth and should thereby stabilise the housing market. 
For overall economic growth it means that it should be somewhat lower than would otherwise be the case. Furthermore, the central bank does not need to take care of regional or sectoral excesses. Combined with a more subdued growth rebound it can refrain from hiking rates for longer. Or put differently, the central bank does not need to raise rates in order to break the neck of a housing boom (and thereby killing the economy) but can instead focus on the overall economic developments. In this case, it should also take longer for inflationary pressures to materialise amid an overall less pronounced growth recovery. On the other side, if a downturn hits, it should also be milder and shorter as the previous excesses were smaller and there are more instruments available (easier capital rules, lending standards) to counteract the downturn than was the case in earlier business cycles. 
As a result, the introduction of macro-prudential policies should help to lower macro-economic volatility further and serves as a partial substitute for traditional monetary policy. This can be seen with the example of Switzerland. The Swiss National Bank introduced a floor in the EURCHF rate in 2011 in order to prevent a strong currency from driving the economy into a deflationary recession. However, doing so meant giving up implementing an independent monetary policy. Effectively, the SNB can not hike rates for as long as the ECB does not hike rates or it needs to give up on its exchange rate target. The resulting loose monetary policy environment (zero rates and aggressive balance sheet lengthening) provided fuel to an already existing housing market upturn. In order to slow down the housing market, the Swiss government has – on the request from the SNB – increased banks' counter-cyclical capital buffers for mortgages for the second time in January this year. This measure should promote a less loose environment in the mortgage market while at the same time allows the SNB to conduct its easy monetary policy for the broader economy for longer. 

For markets, the lower macro-economic volatility should be mirrored in lower financial market volatility across asset classes. Moreover, the volatility of central bank rates should drop even more as in those currency areas where macro-prudential policies play a more important role, policy rates need to be changed by less. This also means that respective central banks can wait longer before they revert to rate hikes.This all argues in favour of carry and of less liquid products across financial markets as well as for an environment of lower risk premia and flatter curves than at similar stages during previous business cycles.

EM slowdown should not threaten European and US recovery

Currencies of non-commodity producing developed economies appreciated significantly over the past twelve months. Moreover, growth has been weakening in a large number of emerging markets. Does this threaten the growth recovery underway in Europe and the US? I do not think so as the upward pressure on EUR, GBP and USD results from capital flowing back into these areas, providing for looser monetary conditions which works against the fx-induced monetary tightening. Moreover, while exports going into EMs and commodity producers should be negatively affected, the European economies are mostly dependent on each other and therefore might find themselves in a mutually reinforcing recovery.

During the past decade, emerging markets have grown strongly and a lot of capital has flown into the emerging markets world. Additionally, as EM have a high commodity intensity of growth, the demand for commodities increased significantly. Coupled with low growth in commodity supply, this lead to the commodities super-cycle. However, higher commodity prices put upward pressure on European (ex Norway) and US inflation and downward pressure on growth. Thereby, it worsened the debt crisis of recent years and lead to more capital flowing out of Europe/the US into EMs and commodity producers. Last year, however, this process went into reverse. The fundamental environment for a large number of Emerging Markets and commodity producing economies has been deteriorating amid the build up in (private sector) indebtedness, loss of competitiveness, rising current account deficits/falling surpluses and growing political risks. The fundamental supply-demand balance for commodities has deteriorated as well amid higher supply growth on the back of the previous rise in investment and lower demand growth due to weaker growth in the commodity intensive emerging markets. On the other side, systemic risks in the Eurozone have receded, real growth in Europe and the US is slowly rising and QE draws to an end, leading to upward pressure on UST, Gilt and to a lesser extent Bund yields.    
 

Developed markets and commodities: From a vicious to a virtuous cycle

  Source: ResearchAhead

In turn, capital has started to flow back out of EMs and commodity producers into Europe and the US, leading to strong upward pressure on currencies such as EUR, GBP and USD. Thereby, the previous vicious cycle has given way to a virtuous cycle. Commodity prices have stopped rising/been dropping. This puts downward pressure on inflation but supports real growth. This in turn, eases the debt crisis and helps to improve fiscal budgets. This process has much further to run and the trends of recent quarters where DM assets outperform vs. EM assets - with EUR, GBP, USD appreciation vs. a broad basket of currencies, EM vs. DM spread widening and DM equity market outperformance – can continue. While the appreciation in EUR, GBP and USD acts to tighten monetary conditions, it also props up asset prices and provides for an improvement in financing conditions – especially in the Eurozone periphery – which constitutes a loosening of monetary conditions. Just as EM equity markets dropped significantly in recent months, DM equity markets moved higher. Furthermore, as the chart below shows, sovereign CDS in Europe and the US fell sharply while sovereign CDS in emerging markets rose significantly. 

12m change in 5-year sovereign CDS

Source: Bloomberg

Moreover, the export environment should improve despite the stronger Euro and a more challenging environment for emerging markets and some commodity producers. The table below shows exports in % of GDP for Eurozone countries. The first row shows exports going to other Eurozone countries, the UK, Switzerland, Sweden, Denmark (i.e. Western Europe ex Norway) and the US. The second row contains exports relative to GDP going to Emerging and Developing countries. The final row shows the ratio of the two numbers. Exports to Western Europe and the US far outweigh those going into the EM world. The Euro did not appreciate much vs. these currencies (it even depreciated slightly vs. CHF and GBP). Only in the case of the USD has it appreciated meaningfully over the past year. However, with a rise of approx. 6% this should not be enough to negate rising demand on the back of higher US growth. In turn, export demand for Eurozone countries (and the UK) should improve given that they are mostly dependent on each other, thereby mutually reinforcing their cyclical upswing!