ECONOMIC REPORT: CENTRAL BANK DIVERGENCE AND NEGATIVE INTEREST RATES
APRIL 2016
Previously, central banks in the U.S., Japan, Europe and Switzerland all adopted the same policy
of an accommodative monetary stance, easing, and stimulus policies. Now, this is no longer so and an
emerging contrast is forming. Over the past half decade, the U.S. Federal Reserve had embarked upon
Quantitative Easing I, QE II, QE III, and QE IV, in addition to lowering the Federal Funds Rate to 0.25%,
its lowest ever. Other central banks around the world aligned their policies with those of the US. But,
starting in 2015, the US stopped its QE programs, which were essentially money printing. Then, the Fed
enacted its first interest rate hike in over half a decade by raising the Fed Funds Rate from 0.25% to
0.50%. This represents divergence from other central banks which are keeping stimulus and near-zero, or
even negative interest rates in place.
Recently, the European Central Bank modified its Targeted Long-term Refinancing Operations
by lowering the rate to negative 40 basis points. What does this mean? This means that when commercial
banks in the EU borrow money from the European Central Bank, that the European Central Bank pays
the commercial banks 40 basis points per year on the loan amount extended to the commercial banks. It
means getting paid to "borrow" money! The purpose, of course, is to encourage banks to borrow from the
ECB in order to deploy money and lend it into the EU economy to businesses. That is the goal, but as the
Fed discovered during the past six years, expanding the supply of credit does not necessarily result in
direct lending into the economy. The reason is that many US banks borrowed from the Fed but then
recycled the money right back into the purchase of U.S. Treasury Notes without necessarily lending to
middle-market businesses.
There are a number of opportunities this creates. First, within equities, European exporters are
poised to continue to do well. As European goods can be purchased at cheaper prices, there will be
increased demand for the goods and services of European and Japanese exports. This is typically
supportive of equity valuations. Car makers, glass makers, pharmaceutical manufacturers, and
information technology companies abroad are areas that benefit.
Recently, Janet Yellen softened the tone of the Fed in urging caution on future interest rate hikes.
As the market was expecting a faster rate of interest rate hikes, these statements were actually stimulative,
causing a rally in equities and fixed income. Within fixed income, the Interest Rate Arbitrage strategy
continues to do well as bonds are rallying. Both investment grade and high yield bonds within the US are
participating in the rally. Bond prices had impounded multiple potential rate hikes. Now that many of
those hikes will not materialize, prices are rising.
The U.S. Yield curve remains positively sloped. Earlier in the year, there was much chatter on
CNBC and Bloomberg of a potential recession. But, this ignored the shape of the yield curve which
remained sloped positively upward. (A positively sloped yield curve does not auger recession.)
Disclaimer
The purpose of this newsletter is to express the views and capital market observations of Princeton Asset Management, LLC. The views expressed in this newsletter represent the views of Princeton Asset Management, LLC only. This is not a recommendation to buy or sell. Also, clients are invested in different strategies which bear different risk and return objectives. The information contained in this newsletter is not investment advice and should not be treated as such.