Tuesday, 4 October 2016

Global Monetary Spillovers and Bank of Canada Independence

In a recent post, I discussed The Breakdown of Faith in Unconventional Monetary Policy. Zero interest rate policy (ZIRP), quantitative easing (QE), forward guidance on policy rates and, more recently, negative interest rate policy (NIRP) have been undertaken in various forms and to varying degrees by the four major DM central banks, the US Federal Reserve (Fed), the European Central Bank (ECB), the Bank of Japan (BoJ) and the Bank of England (BoE). Some smaller central banks have dabbled in unconventional monetary policies (UMPs), including the Swiss, Danish and Swedish central banks. 

But, from the perspective of other countries, where the domestic central banks have not been aggressive participants in UMP, the important question is how do these policies affect their economies, their financial markets and the independence of their monetary policies. Recent research has focused on the global spillovers from UMPs of the major central banks into the monetary policies and financial conditions of other global economies, especially EM economies and some of the small open DM economies. This research has found strong evidence that UMP has spilled over into other economies, complicating the conduct of national monetary policies and, at times, creating risks to financial stability.

Evidence of Spillovers

In a their paper, International Monetary SpilloversBoris Hofmann and Előd Takáts of the Bank for International Settlements (BIS) state that:
We find economically and statistically significant spillovers from the United States to EMEs [emerging market economies] and smaller advanced economies [including Canada]. These spillovers are present not only in short- and long-term interest rates but also in policy rates. In other words, we find that interest rates in the United States affect interest rates elsewhere beyond what similarities in business cycles or global risk factors would justify. We also find that monetary spillovers take place under both fixed and floating exchange rate regimes.

Jaime Caruana, General Manager of the BIS, in a recent paper entitled, The international monetary and financial system: eliminating the blind spot, makes the following observation:
Most central banks target domestic inflation and let their currencies float, or follow policies consistent with managed or fixed exchange rates in line with domestic policy goals. Most central banks interpret their mandate exclusively in domestic terms. … [L]iquidity conditions often spill over across borders and can amplify domestic imbalances to the point of instability. In other words, the international monetary and financial system as we know it today not only does not constrain the build-up of financial imbalances, it also does not make it easy for national authorities to see these imbalances coming. 
Moreover, the search for a framework that can satisfactorily integrate the links between financial stability and monetary policy is still work in progress with some way to go. The development and adoption of such a framework represent one of the most significant and difficult challenges for the central bank community over the next few years. 
Caruana has identified four channels by which global liquidity conditions can spill over:

  1. through the conduct of monetary policy: easy monetary conditions in the major advanced economies spread to the rest of the world via policy reactions in the other economies (e.g., easing to resist currency appreciation and maintain competitiveness);
  2. through the international use of currencies: most notably, the domains of the US dollar and the euro extend so broadly beyond their respective domestic jurisdictions that US and euro area monetary policies immediately affect financial conditions in the rest of the world. … A key observation in this context is that US dollar credit to non-bank borrowers outside the United States has reached $9.2 trillion, and this stock expands on US monetary easing;
  3. through the integration of financial markets, which allows global common factors to move bond and equity prices. Uncertainty and risk aversion, as reflected in indicators such as the VIX index, affect asset markets and credit flows everywhere; and 
  4. through the availability of external finance in general, regardless of currency: capital flows provide a source of funding that can amplify domestic credit booms and busts. In the run-up to the global financial crisis, for instance, cross-border bank lending contributed to raising credit-to-GDP ratios in a number of economies.

Caruana concludes:
Through these channels, monetary and financial regimes can interact with and reinforce each other, sometimes amplifying domestic imbalances to the point of instability. Global liquidity surges and collapses as a result. What I have just described is the spillovers and feedbacks – and the tendency to create a global easing bias – with monetary accommodation at the centre. But these channels can also work in the opposite direction, amplifying financial tightening when policy rates in the centre begin to rise, or even seem ready to rise – as suggested by the taper tantrum of 2013.

Implications of Spillovers for Canada

For smaller, open DM economies like Canada, the spillovers from the major central banks’ UMPs are readily visible. 

When the major central banks lowered their policy rates to near zero, the Bank of Canada (BoC) did likewise. This was partly driven by concerns about domestic economic weakness and partly to resist appreciation of the Canadian dollar and the resulting loss of competitiveness. When the BoC became concerned about what proved to be a temporary increase in inflation and raised its policy rate in 2011, the Canadian dollar appreciated strongly.

When major central banks engaged in Quantitative Easing, through large-scale purchases of their own sovereign debt, demand for close substitutes like Canadian sovereign debt increased and forced down Canadian long term government bond yields.

When major central banks, including the Bank of Japan, ECB and BoE moved to NIRP, the Bank of Canada announced that its research showed that it, too, could lower its policy rate below zero if necessary.  

The net result is that Bank of Canada policy has become both constrained by and heavily influenced by the UMPs of the major central banks. Canadian liquidity and financial conditions reflect not just the BoC’s policy rate setting, but also and more importantly, the extraordinarily accommodative policies of the major central banks. The BoC has had no choice but to keep its policy rate low. Failing to do so would have created even greater exchange rate appreciation that would have stunted growth even more and pushed inflation even further below the 2% target.

The ultra-low interest rates imported through global financial markets, have led to a credit boom. The credit boom has been characterized by heavy borrowing by Canadian households and some sectors of Canadian business, such as the energy sector. 

The heavy mortgage borrowing by households has contributed to overheated housing markets in Vancouver and Toronto. As I have argued in a previous post, the housing boom in these cities was amplified by easy credit policy by the People's Bank of China (PBoC), which saw synchronized housing price surges in large Chinese and Canadian cities. With inflation below target and the BoC unable to raise its policy rate to quell this overheating, federal, provincial and municipal governments have intervened with macro-prudential policies, such as tighter mortgage rules, the recent tax on foreign homebuyers in Vancouver, and the federal government's closing of the capital gains tax loophole for foreign homebuyers.

When energy prices were high, supported by near-zero policy rates and the liquidity boost provided by quantitative easing by the major central banks, Canadian energy companies issued large amounts of corporate debt at low rates. When the surge in global investment in fracking technology spurred strong growth in energy supply at a time of lacklustre demand growth, energy prices collapsed and default rates jumped sharply in the energy sector. 

The integration of global financial markets means that global uncertainty and risk aversion is instantly transmitted to Canadian markets for stocks and bonds. Canadian markets and asset prices are now as sensitive, if not more sensitive, to changes in policies of the major central banks as they are to changes in Bank of Canada policy.

Monetary Spillovers and Central Bank Independence

This raises the important question of whether the central banks of smaller open economies, like Canada, can pursue independent monetary policy.

Canada's Nobel Prize winning economist, Robert Mundell, laid the groundwork with what he referred to as "the impossible trinity" and what others have called the "monetary trilemma". As explained by Paul Krugman in 1999,

Mundell proposed the concept of the "impossible trinity"; free capital movement, a fixed exchange rate, and an effective monetary policy. The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession.

Wikipedia summarizes with the help of the diagram below: "The Impossible Trinity" or "The Trilemma", in which two policy positions are possible. If a nation were to adopt position a, for example, then it would maintain a fixed exchange rate and allow free capital flows, the consequence of which would be loss of monetary sovereignty.

When Canada let its exchange rate float in 1970, it opted for position b on the chart, accepting the need for a flexible exchange rate because it wanted to maintain free international capital mobility and a sovereign (i.e., independent) monetary policy.

But global monetary policy spillovers now challenge the ability of smaller central banks to conduct an independent monetary policy, even if the central bank is prepared to maintain a flexible, market-determined exchange rate. 

In a paper entitled Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence, Hélène Rey of the Kansas City Fed argues,
[M]onetary policy [of] the center country [i.e. the major central banks] … affects leverage of global banks, credit flows and credit growth in the international financial system. This channel invalidates the "trilemma", which postulates that in a world of free capital mobility, independent monetary policies are feasible if and only if exchange rates are floating. Instead, while it is certainly true that countries with fixed exchange rates cannot have independent monetary policies in a world of free capital mobility, my analysis suggests that cross-border flows and leverage of global institutions transmit monetary conditions globally, even under floating exchange-rate regimes.

Implications for Canadian Monetary Policy 

At a minimum, it is high time that the Bank of Canada openly analyze and discuss with the public, the influence that the major central banks' unconventional monetary policies are having on the Canadian economy and financial markets.

How will the future paths of the major central banks policies influence and constrain the policies of the Bank of Canada?

With the Fed signalling that it plans to resume a gradual tightening of policy at a time when the Canadian economy is struggling to adjust to much lower prices for oil and other commodities, the likely spillover will be a premature and possibly excessive, tightening of Canadian financial conditions. Should the Bank of Canada keep pace with Fed tightening or hold the line on Canada’s policy rate and thereby encourage further depreciation of the Canadian dollar? Or should it cut its own policy rate to offset the spillover of tighter financial conditions arising from Fed tightening?

If Fed tightening pushes up global bond yields (and therefore Canadian mortgage rates) how should the BoC respond to the likely fallout in the Canadian housing market if housing prices experience a sharp correction? 

If US and global growth falters and the Fed returns to more aggressive use of UMP, including a zero or even negative Fed policy rate and a resumption of QE, can the BoC afford not to follow?

If the BoJ and/or the ECB push policy rates further into negative territory, should the Bank of Canada be prepared to follow?

If Japan adopts ‘helicopter money’ or central bank financed fiscal stimulus, should the BoC consider the same direction?

Is there any alternative to mimicking the unconventional policies of the major foreign central banks? If the answer is yes, then how will the tradeoffs between the interests of savers and borrowers and between the interests of exporters and domestic consumers be balanced? 

If the answer is no, then what remains of the independence of the BoC? If its' policy rate and Canadian bond yields reflect spillovers from foreign central bank UMPs can the BoC independently pursue its' 2% inflation target? Are its policies not then dominated by foreign central bank actions or possibly by its own government’s needs to finance new spending and hold down debt service costs through financial repression?

These are tough and important questions that are not even being discussed in Canada.

Sunday, 2 October 2016

Global ETF Portfolios for Canadian Investors: 3Q16

The stay-at-home strategy continued to perform well in 3Q16 after three years of underperforming the globally diversified ETF portfolios that we track in this blog. Crude oil prices finished September little changed from where they were at the end of June. The US Fed remained on hold but laid the groundwork for another tightening move before the end of the year. Meanwhile, the Bank of Canada stood pat and talked of rates staying low for long.

The price of WTI crude oil, which began the year at US$37 per barrel finished 3Q16 at US$48/bbl, virtually unchanged from the 2Q closing level. The BoC decision to stand pat, combined with the Fed continuing to signal one tightening before yearend, sparked a 1.6% depreciation in the Canadian dollar in 3Q, ending September at US 76.2 cents, down from 77.4 cents at the end of June.

Flat crude oil prices combined with the 1.6% depreciation in the Canadian dollar in 3Q16 provided modest headwinds for stay-at-home portfolios. Unhedged global ETF portfolios were able to outperform in a quarter when both stocks and bonds continued to rally. A stay-at-home 60/40 investor who invested 60% of their funds in the Canadian equity ETF (XIU), 30% in the Canadian bond ETF (XBB), and 10% in the Canadian real return bond ETF (XRB) had a total return (including reinvested dividend and interest payments) of 4.0% in Canadian dollars. Most of the unhedged Global ETF portfolios that I track in this blog posted slightly stronger gains for 3Q16. Since we began monitoring at the beginning of 2012, the unhedged Global ETF portfolios have vastly outperformed the stay-at-home portfolio.

Global Market ETFs: Performance for 3Q16

In 3Q16, with central banks remaining dovish and the USD appreciating 1.6% against the CAD, global ETF returns favoured foreign equities. In CAD terms, 18 of the 19 ETFs we track posted positive returns, while just one ETF posted a loss for the quarter. The chart below shows 3Q16 returns (blue bars) and year-to-date returns (green bars), in CAD terms, including reinvested dividends, for the ETFs tracked in this blog.

The best gainers in 3Q16 were global equity ETFs, including Japan equities (EWJ) which returned 10.8% in CAD terms, followed closely by US small cap equities (IWM) at 10.7% and emerging market equities (EEM) at 10.2%. The best performing bond ETFs were US High Yield Bonds (HYG) which returned 6.1% in 3Q16, followed by non-US inflation-linked bonds (WIP)  at 5.4%. The Gold ETF (GLD) returned 1.0%. The worst performer was the commodity ETF (GSG) which returned -3.0% in CAD terms.

For 2016 year-to-date, the best performing ETFs in CAD terms were the gold ETF (GLD), the Canadian equity ETF (XIU), and the Canadian long bond ETF (XLB). The worst year-to-date performers were Eurozone equities (FEZ), commodities (GSG) and Japanese equities (EWJ).

Global ETF Portfolio Performance for 3Q16

In 3Q16, the Global ETF portfolios tracked in this blog all posted solid returns in CAD terms. This was true whether USD currency exposure was hedged or left unhedged, but the unhedged portfolios performed better, reversing the pattern of the previous two quarters.

A stay-at-home, Canada-only 60% equity/40% Bond Portfolio returned 4.0% in 3Q16. Among the global ETF portfolios that we track, risk balanced portfolios outperformed in 3Q16. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, benefitting from strong levered bond returns, gained 4.7% in CAD terms if unhedged, but had a lower return of 3.4% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, gained 4.4% if unhedged and 3.2% if USD-hedged.

The Global 60% Equity/40% Bond ETF Portfolio (which includes both Canadian and global equity and bond ETFs) returned 4.4% in CAD terms when USD exposure was left unhedged, and 3.2% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 3.9% if unhedged and 2.9% if USD hedged.

On a year-to-date basis, the all Canadian stay-at-home ETF portfolio remained the best performer, returning 10.7% ytd, outperforming all of the unhedged global ETF portfolios that we monitor in CAD terms. If USD exposures were hedged, however, the best performing portfolio was the Global Levered Risk Balanced Portfolio, which returned 15.0% in CAD terms.

Looking Ahead

The key market events of 2016 that have influenced global ETF portfolio returns in CAD terms were: the market's rising conviction that slow global growth and below-target inflation in the major DM economies will delay and moderate any tightening by the Fed and encourage further easing by other major central banks; the BoC's signalling that its policy rate will likely remain low for long; and a gradually improving balance between global demand and supply of crude oil. These events occurred against a backdrop of further downward revisions to global growth  and inflation expectations and rising political uncertainty as the UK voted for Brexit and the polls tightened in the US presidential election race. So far, markets have shrugged off the political uncertainty and been encouraged by continued extremely accommodative monetary policies.

After rising at a 2.5% annualized pace in 1Q, Canada's economy contracted at a 1.6% pace in 2Q, in part due to the disruption caused by the Fort McMurray wildfires. The expected 3Q16 rebound in growth is encouraging but in reality only returns the Canadian economy to subpar year-over-year growth of just over 1%. US growth averaged just 1.1% in the first half of 2016, and the Atlanta Fed's GDP Now forecast currently points to 2.4% growth for US real GDP in 3Q. On balance, 2016 growth expectations have been revised down quite sharply, for Canada to 1.2% currently from 1.9% in December and for the US to 1.5% currently from 2.4% in December.

Global growth and inflation prospects have also cooled. According to JPMorgan, global growth for 2016 is now projected at 3.1%, down from the December consensus forecast of 3.4%. Global consumer price inflation is now projected at 2.3%, down from the December consensus forecast of 2.7%. 

Meanwhile, Fed Chair Janet Yellen's message has shifted from firmly on hold ahead of the Brexit referendum to clear support for a rate hike before the end of 2016 now. At the same time, the Bank of  Canada Governor Poloz has made it clear that the BoC is content to pass the stimulus baton to Finance Minister Morneau, who will soon present a Fiscal Update that will confirm that the government is content to pursue large and growing deficits in the name of "growing the economy".

The key event in the final quarter of 2016 is, without a doubt, the US presidential election. While it can be argued that Trump's economic policy platform, if effectively implemented, would be more advantageous to Canada than Clinton's, there is no doubt that the Canadian voters who gave the Trudeau Liberals a strong parliamentary majority would prefer to see Clinton win. From a market perspective, it appears that risk markets that have so heavily depended on central bank unconventional monetary policies, would prefer a Clinton victory as more likely to see a shift toward a more expansionary fiscal policy and perhaps eventually "helicopter money". 

This leaves global markets in a potentially vulnerable position. Equity market valuations are increasingly stretched. Government bond market valuations also remained stretched as global 10-year bond yields continue to test new lows.

The declines in global bond yields are a reflection of growth disappointments and falling inflation expectations around the world and the market's assessment that this will result in continued experimentation with unconventional monetary policies. We are living in an upside down world in which weak growth and disinflation seem to lift financial asset prices because investors expect that such outcomes will spur even more accommodative monetary policy.

In a continuing uncertain environment, characterized by sluggish global growth, record high debt levels, unprecedented central bank stimulus, and a high level of political risk, remaining well diversified across asset classes, with substantial exposure to USD-denominated assets and with an ample cash position continues to be a prudent strategy.