How will the Covid-19 virus change the role of central banks?
The role of central banks
Central banks generally have three main roles: they ensure low and stable inflation (price stability), protect financial stability and help governments pay bills (monetization). The importance of these roles and the emphasis placed on them are changeable over time and sometimes contradictory. For example, in the 30 years preceding the global financial crisis (GFC), most central banks focused solely on price stability. This approach has led to the biggest financial crisis since the Great Depression, so central banks have expanded their offer to include financial stability. Direct monetization has gone out of fashion in recent decades – with a notable exception (Venezuela, Zimbabwe). Central banks often helped governments pay bills, especially during the war. Today, they have stepped in to face COVID-19, while avoiding an increase in bond yields.
No appropriate time for a crisis
Public sector balance sheets welcoming the virus were not in great shape. At the end of last year, the total public debt of the G7 group of large industrial countries amounted to almost 120% of gross domestic product (GDP) and was higher than at the end of the First or Second World War. This year, when budget deficits are to rise sharply and production is likely to fall, this figure is likely to rise to around 140% of GDP.
Chart: Public sector balance sheets, G7 Countries Government Debt:
Source: Haver Analytics, IMF, RCieSolution Research, Data as of April 30, 2020; for illustrative purposes.
Not so long ago, current readings would be considered extremely unbalanced. At the beginning of the European debt crisis, the Greek debt-to-GDP ratio was 146%. Such increased debt ratios are no longer considered unbalanced because interest rates are low. The question is how low interest rates must be for the major developed economies to remain solvent?
What level of interest rates maintains debt-to-GDP stability?
We have calculated debt stabilizing interest rates (DSIRs) for selected developed economies. This simple calculation estimates the average cost of financing needed to maintain a stable debt-to-GDP ratio. It is based on three variables: the level of public debt, the size of the original budget balance (excluding interest payments) and the projected nominal GDP growth. For illustrative purposes, we use the International Monetary Fund’s 2021 public debt and primary balance forecasts and our own forecasts for nominal GDP growth.
Chart: Low interest rates. Hypothetical interest rates stabilizing debt*
Source: Haver Analytics, IMF, RCieSolution Research. As of April 30, 2020; for illustrative purposes.
* Average cost of financing required to maintain a stable public debt-to-GDP ratio of 2021; Taking into account the IMF’s forecasts for the original budgetary position and outstanding public debt in 2021 and RCieSolution’s forecasts for the nominal GDP growth trend.
According to our simulation, DSIRs fluctuate between 1.7% in Germany to -1.1% in Great Britain, -1.3% in the United States and -1.5% in France. This does not mean that the US will set the interest rate at a negative level, we still consider it unlikely. This means that public debt will move to an explosive path, unless the average cost of financing is kept very low, especially in countries with negative DSIR. Central banks especially intervene there. In recent weeks, many central banks have launched, reopened or extended large-scale government bond purchase programs. A mechanism similar to the response from the GFC, with a significant difference. The response to the Covid-19 crisis was faster and wider: in March and April, the US Federal Reserve bought $ 1.5 trillion in Treasury debt, which took four years during the GFC. We expect much more. The goal is also different: central banks now speak much more openly about the relationship between their purchases and government funding costs.
Fiscal and monetary policy, do demarcation criteria still apply?
Very few central bankers would admit that they are making money on government shortcomings. But they do, and more importantly, they should do it in the current circumstances. As in times of war, central banks now have few options but to enter into a relationship that blurs the distinction between monetary policy and fiscal policy. Over time, governments and voters will have to decide how best to deal with the very high level of public sector debt. Lack of payment (default), savings programs (austerity) and higher inflation are among the possible options. Alternatively, they could diminish the importance of public debt, as some proponents of modern monetary theory would recommend. These are the issues for the next day. Until then, it is important that interest rates and bond yields are low.
In recent weeks, central banks have clearly shown that they have both the ability and willingness to keep bond yields in check. So at a time when the global forecast is high risk, the convincing view is that interest rates and bond yields will still be close to zero and in some cases below zero.
It is very likely that low interest rates will last longer
In the face of Covid-19, long-term yields on developed markets have fallen. Market participants appear to be uncertain how to incorporate mass fiscal and monetary easing into their expectations of medium-term rates. The long-term debt profitability model indicates continuing low interest rates over the next few years. The long-term intervention of central banks in global government bonds is likely to remain a decisive factor. Additional flows of private risk-avoiding savings will also put significant pressure on a decline in long-term profitability. In the euro area, the cumulative flow of private financial savings has so far exceeded the volume of QE. We expect that the rapidly growing number of fresh financial savings will not be accompanied by a proportional increase in the free movement of safe assets. Public debt ratios do not fully explain the levels of profitability in developed markets in the medium term. Long-term yields may increase sharply in the face of inflation shock or monetary policy error. But even in these cases, growth would be limited. The credit spreads of the euro zone countries have become much more sensitive to central bank interventions and private sector savings than to any debt-related factors.
Projection of medium-term interest rates in the United States and the euro zone
We have identified a number of factors that have proved to be very important for the medium-term development of interest rates in the US and the euro zone in recent years:
- Nominal GDP trend (long-term inflation expectations + potential real growth)
- QE of the central bank (volumes, length and reinvestment policy) and its impact on the supply of government bonds and the risk associated with the duration of bonds
- Long-term neutral rate expectations (using an adaptive algorithm of interest rate expectations)
- Short-term expectations regarding monetary policy rates reflected in the forward money market
- Risk aversion in the private sector and a tendency to accumulate financial savings (demand for safe assets)
The models suggest that the interaction of the above factors will cause a low level of interest rates in the medium term for both the US and the euro area, especially in the context of central banks exerting significant purchasing pressure on Treasury bond markets. These results become intuitively understandable if we look at the elements of the model. First, the growth shock associated with Covid-19 in 2020 should reduce nominal growth. In our model, this will immediately translate into long-term rates, because any decrease in nominal growth by 1% Q/Q reduces the balance of long-term interest rates by about 10 bp (currently at 3% in the euro zone). Secondly, we expect inflation readings to be low first (deflation effect, especially through energy prices), and then we expect a moderate upward move. We believe that the risk of inflation is moderate, skewed. Private investors (households and corporations) will increase their financial savings and at the same time be more risk-averse (stockpiling). The political challenge is to reintroduce balancing measures into the economy and capital markets, by restoring faith in the future or by destroying the credibility of money as a measure of value retention. It will be a long-term process. In the meantime, we expect the euro zone to generate an increase in private financial savings that can easily exceed the increase in the public deficit. The trade surplus in EMU, growing due to a decline in imports, caused by the shrinking domestic demand and the fall in oil prices, confirm this direction.
Chart: USA, 10 years, base inflation expectations
Source: Refinitiv, RCieSolution
If you are interested in getting to know the assumptions and results of the model, please contact us.
The European Central Bank is trying to close the funding gap triggered by governments
In response to the virus crisis, gross financial needs may amount to EUR 800-900 billion for the euro zone and only part of them will be covered by long-term bond issues. In addition to state guarantees, depending on the extent to which they translate into real financial needs, these needs include discretionary expenses (investments, tax cuts, etc.) and additional social security expenses (automatic stabilizers). As a result, the public deficit will increase. In Germany, we expect the deficit to reach 7% of GDP, in France 11%, in Italy 13.6%, and in Spain 7.8%. This year, we expect gross issues of long-term government bonds in the amount of EUR 1250 billion, of which EUR 450 billion can be attributed to the Covid-19 crisis. This corresponds to a 40% increase compared to last year and 50% compared to the initial financing plans. This huge increase in gross issuance may suggest a significant increase in the supply of long-term euro-denominated government bonds. Indeed, after taking into account buyouts, the outstanding amount would increase by EUR 770 billion this year (net issuance). This would mean an 11% increase in the outstanding volume. The situation varies considerably from one country to another. While growth in Germany and Greece is close to 20%, in Belgium and Portugal it is below 5%.
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The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.