Asset management

2 September 2013

Economist Insights One-downmanship

Both the ECB and Bank of England have recently adopted forward guidance of one form or another. But judging by market reaction, this seems so far to have been unsuccessful and the recent improvement in the economic outlook has not helped. Forward guidance in Europe is also impacted by rising US bond yields. While the ECB and the Bank of England in theory have the necessary levers to anchor shortterm rates, they may need to engage in one-downmanship to convince markets that their economies are not as strong as the US and therefore their yields do not need to rise as aggressively as the market is currently pricing. In the past few months, the two largest central banks in Europe have changed their approach to monetary policy and adopted forward guidance of one form or another. The Bank of England (BOE) has introduced a threshold guidance based on unemployment, similar to the US (see Economist Insights, 12 August 2013). The European Central Bank (ECB), meanwhile, has introduced a more flexible time-based guidance. Forward guidance can be considered the frontier of current thinking in monetary policy. Quantitative easing (QE) used to be the frontier, but doubts about its effectiveness combined with concerns about the side effects have encouraged central bankers to look for alternatives. With policy interest rates close to their zero lower bounds, it is hoped that forward guidance can stimulate the economy without the central bank actually having to do anything. A central bank can commit to keeping interest rates low for longer than the expected pace of economic activity would normally suggest. The trick with forward guidance is that while the central bank cannot in practice push the policy rate into negative territory, it can keep real rates (accounting for inflation) negative for longer and, in theory, incentivise people to bring forward consumption and investment. Judging by the market reaction since its introduction, forward guidance in Europe is at risk of being remembered as one of the most unsuccessful experiments in monetary policy. Instead of keeping rates lower, the sovereign yield curve has actually steepened significantly in both the UK and the Eurozone. Markets are now pricing in two rate hikes in the Eurozone and three in the UK by the end of 2015 (see chart). This is in spite of the BOEs announced intention not to hike rates before 2016 and the ECBs guidance that it expects to remain on hold for an extended period of time that goes beyond the policy-relevant horizons (which for the ECB would mean close to 2016). Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

The misunderstanding Central bank policy rate as implied by forward guidance and market expectation by Dec. 2015 A) Bank of England 1.50 1.25 1.00 0.75 0.50 0.25 B) ECB 1.50 1.25 1.00 0.75 0.50 0.25 C) Federal Reserve 1.50 1.25 1.00 0.75 0.50 0.25 May-13 Market implied Jun-13 Jul-13 Aug-13

Forward guidance for Dec. 2015

Source: Bloomberg, UBS Global Asset Management Note: Market pricing is based on EONIA and SONIA, making the assumption that the basis spreads between the central bank rate and these rates are constant. The basis spread could vary due to changes in quantity of central bank reserves in the system.

There are two main reasons why the markets have not reacted to forward guidance as the central banks would have hoped. The first is that markets may not think that the commitment is credible. Markets expect that the central banks will revert to their standard reaction function as soon as growth and inflation start to rise. This is likely to be particularly true for the ECB. The ECB is arguably the least committed among the forward-guiding central banks. In contrast to the BOE or Federal Reserve, the ECB has no leeway to interpret its mandate flexibly to justify remaining on hold for a specific length of time. The ECBs forward guidance is really just telling the market that it expects growth and inflation to be low enough to allow rates to be unchanged for an extended period of time. If markets think that those expectations are too conservative, then they will expect the ECB to break its promises at the first whiff of inflation. The second explanation for the apparent failure of forward guidance may be that the market sees the timeframe to reach the central banks threshold as too pessimistic. This could well be the case in the UK, as with current unemployment at 7.8% markets might believe that threshold of 7% will be achieved earlier than 2016 as the Bank of England forecasts. One thing seems to be sure the recent improvement in the economic outlook has definitely not helped the effectiveness of forward guidance. GDP growth in the UK and Eurozone surprised substantially on the upside in the second quarter. Furthermore, survey indicators such as the purchasing manager indices have recently moved to their highest values since mid-2011. Seeing a stronger economy, markets have rapidly re-priced their expectations for the future path of monetary policy. Forward guidance in Europe is also imperilled by rising bond yields in the US. Yields on gilts and bunds have risen in correlation with US treasuries as investors accelerated their withdrawal out of safer sovereign bond markets. In contrast to Europe the market expectation for the US rate path is arguably far more aligned with the Feds projections and is warranted by the resiliency of the recovery. But historically European government bonds have moved in sympathy with the US, so the big challenge for the BOE and the ECB will be to limit the contagion from the US once tapering of QE begins. When markets start pushing yields above levels that are appropriate for the economy, the recovery is put at risk because borrowing costs are rising too fast.

What can a forward-guiding central bank do to counteract this kind of contagion? The first option would be to wait and see if the recovery is strong enough to withstand the higher rates, taking the risk that this could result in weaker economic activity. If the recovery is not strong enough, then market expectations should automatically correct as soon as the recovery begins to falter (and hopefully this would not be too late to reverse the damage). Alternatively, the central bank could act to anchor interest rates even more securely at the front end of the curve, until certain that the recovery is on a sustainable footing. While this would have little impact on the long end of the yield curve, in the UK and the Eurozone this is far less important because most lending to the private sector is linked to short-term rates. Furthermore, a steeper yield curve would make sense as long as the central bank believes that the recovery is in place and only wants to prevent short-term spillovers to the economy from markets getting ahead of themselves. Both the ECB and the BOE in principle have the necessary levers to anchor short-term rates. The first tool is clearly all about communication and the threat of intervention. Yet communication has not worked very well so far. The rather dovish first public speech by the new BOE Governor Mark Carney failed to convince markets. It is likely, however, that the effectiveness of communication will improve the higher interest rates go. If communication does not really work, both central banks still have the option to cut the policy rate. While the threshold for such action is still very high, it cannot be completely excluded, especially if the recovery starts to show some sign of softening. Given that there is really only room for one further cut, both central banks may be inclined to keep this move in reserve. Alternatively, the Bank of England could be bold enough to expand QE at the front end of the curve while the ECB could launch a new 12-18 month fixed-rate long-term refinancing operation (LTRO). We are used to politicians engaging in one-upmanship when talking about their economies: they always want to talk about why their economy is better than anyone elses. For the ECB and the BOE, the challenge will be convincing the markets that their economies are not as strong as the US and therefore their yields do not need to rise. If they fail in this one-downmanship then the markets risk proving the central bankers right and stifling the recovery.

The views expressed are as of September 2013 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fund-specific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. This document is intended for limited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publication without the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is accepted for anyerrors or omissions herein. Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. Theinformation and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith. All such information and opinions are subject to change without notice. A number of the comments in this document are based on current expectations and are considered forward-looking statements. Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of UBS Global Asset Managements best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund. UBS 2013. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 23298