EFTA01437704.pdf

Amercias Edition March 2016 The limits of monetary policy: Are central banks losing their magic touch? Marketing Material EFTA01437704 The limits of monetary policy Amercias Edition I March 2016 2 The limits of monetary policy: Are central banks losing their magic touch? Letter to investors Central bank policy intervention has dominated the investment landscape for the last eight years. As some monetary policy was certainly helpful — at least from a financial market perspective - more and more questions come up where do we go from here? Opinions differ about whether it is a help or a hindrance. With economic growth still stubbornly low in many regions, skepticism has grown about how effective it can be - as have concerns about its possible long-term side effects. This special report should help to understand the limits to central bank policy intervention and the implications for investment. It explains why quantitative easing can be a powerful medicine, it is one which is only very imperfectly understood and which relies as much on investor belief as well as rational calculation to work. The report also spells out why such intervention can have unexpected and possibly negative consequences, for example through the encouragement of capital misallocation and asset class bubbles. But, with central banks likely to persevere with this uncertain cure, we will all have to learn to live with the consequences for some time to come. Uncertainty, of course, will create opportunities as well as risks. You might still navigate around this uncharted investment world in a potentially profitable way. But given the likely background of varied asset class returns, coupled with high levels of volatility, you may need to keep an open mind as to how you invest. To make your portfolio appropriate to your needs, I would suggest focusing on four issues. 1. Returns expectations should be appropriate. Some investors may find it appropriate to lower their returns expectations, given their circumstances, but others will not. The structure of portfolios must reflect this. 2. Risk comes in many forms. For those seeking to maintain returns expectations, increasing risk budgets might be an appropriate approach, especially of if you have a longer-term perspective. In such uncertain times, constructing "airbags" to protect EFTA01437705 portfolio returns may be wise if you are targeting normal or high returns. Remember that while protection has its costs, it may help you sleep better at night. And naturally, higher risk is no promise of higher returns, especially not short- term. 3. Diversify, but flexibly. Whilst I believe the old correlation patterns between asset classes will continue to change, a more flexible approach to diversification might still benefit portfolios. A well-diversified investor, ready to be flexible, can benefit from currency and other trends. You may want to consider investing in alternative assets to help you meet your return targets, but always with due regard to your risk profile. 4. Knowledge is still king. In an increasingly uncertain world, deep local knowledge of the world is also important, to identify structural trends early on and select assets accordingly. I am not suggesting that investing in this environment, with central banks still feeling their way, will be easy or uneventful. But I believe that as an organization we have the skills to help you do it. Past performance is not indicative of future returns No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. Christian Notting Global Chief Investment Officer for Deutsche Bank Wealth Management, Managing Director EFTA01437706 The limits of monetary policy Amercias Edition I March 2016 3 Are central banks losing their magic touch? When markets worry about central banks, they are really fretting about two distinct things. On the one hand, there is the real economy. On the other hand, and usually of much more immediate interest is the question of how central-bank moves will impact financial markets. For much of the period since equity markets bottomed out in 2009, those two questions have been intertwined. Not so long ago, the prices of risky assets, such as equities, seemed like a one-way bet. Bad economic news, such as lackluster U.S. job creation, led markets to expect further monetary stimulus and boosted financial assets. Meanwhile, good economic news also boosted prices of risky assets. Solid job figures, for example, suggested that the economy was healing nicely, but, given the depth of the slump, financial markets rightly expected it would still take a long time for interest rates to return to more normal levels. This cozy era came to a close in 2015, and probably ended for good with the first U.S. Federal Reserve Board (Fed) interest-rate hike last December. Major equity markets began this new age with their worst start of the year since the 1930s, amidst growing concerns that central banks have lost their magic touch. In recent months, financial markets have increasingly seen central banks less as saviors and more as part of the problem. What next? Of course, the range of the federal funds rate at 0.25 to 0.50% remains extraordinarily low by historic standards. What has changed, however, is the balance of risk from a market perspective. Strong U.S. economic figures are now a mixed blessing, while weak figures really are bad news. The pain caused by weakness in U.S. manufacturing, for example, is tangible enough, but the potential gain from more Fed action for now looks distant. The stakes are particularly high for the European Central Bank (ECB) and the Bank of Japan (BOJ), amidst growing concerns that they are running out of options. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The EFTA01437707 information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437708 The limits of monetary policy Amercias Edition I March 2016 4 Central-bank moves and market-mood swings 8,500 9,000 9,500 10,000 10,500 11,000 11,500 12,000 12,500 in index points ECB announces QE China devalues the yuan ECB lowers interest rate, however markets are disappointed Global monetary policy action has been the key driver for equity markets Dax 01/2015 03/2015 05/2015 07/2015 09/2015 ECB hints at further loosening 11/2015 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 01/2016 03/2016 The past year has seen many mood swings in financial markets, as illustrated here by the German Dax. When the ECB announced the large-scale purchase of assets through quantitative easing (QE), that gave equities a boost. The Dax lost steam, once the ECB actually started its QE program. Global equities fell sharply in the summer, after China devalued the Yuan. In fall, it was again the expectation of further loosening that helped equities, while the actual decision disappointed. But why, precisely, are markets worried? To answer this question, we suggest that a EFTA01437709 closer look at the role of central banks is warranted, by considering: 1. The role central banks see for themselves — and how it falls short of what markets have come to expect; 2. The limits of how much extra help central banks can and will provide. Next, we take a more detailed look at: 3. The potential consequences for investors; 4. The specific challenges ahead for the ECB, the Fed and the BOJ The report concludes by presenting some tentative solutions to the dilemma investors currently face from a multi-asset perspective. 1. The role of central banks Sixteen years ago, Mervyn King of the Bank of England (BoE) suggested that "a successful central bank should be boring — rather like a referee whose success is judged by how little his or her decisions intrude into the game itself."1 That's a far cry from what central bankers have been up to in recent years. Ever since the financial crisis of 2009, markets have looked to them for salvation. The main tool used was quantitative easing — buying assets to stimulate money creation. In many market segments, this has turned central bankers from neutral observers to dominant players. But are markets right to have such high expectations of central banks? That reflects a basic misunderstanding of what central banks can, and cannot do. And to see why, think back to what monetary policy was like not so long ago. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. 1 "Monetary Policy: Theory in Practice", Address given by Mervyn King, Deputy Governor of the Bank of England, 7 January 2000 EFTA01437710 The limits of monetary policy Amercias Edition I March 2016 5 Not so long ago, central banks had a clear, but limited task. To be sure, there were small variations in terms of the mandate of central banks around the developed world. But essentially, monetary policy was a decision on when to adjust interest rates — ideally raising them before economic overheating and cutting them in time to mitigate or avoid a looming slump. How quickly an economy would grow in the longer term, though, was largely determined by other factors. That last insight is important. We should remember that there may not be much central banks can do to boost potential growth. Perhaps we need to realize that potential output growth is lower than it used to be. Blaming the Fed for lackluster potential growth is a bit like blaming a referee for the lack of sporting prowess you see among the players on the field. To be sure, a central bank can mitigate the lasting impact of a slump by trying to keep recessions brief, being mindful of the fact that workers who are unemployed for prolonged periods lose some of their skills. When young people struggle to find a job to begin with it can also hurt their prospects for many years to come. This has been a perennial problem in other parts of the world, and may be one of the root causes of economic stagnation in Southern Europe.2 Arguably, the ECB made matters worse, when it prematurely increased interest rates in 2011. By contrast, U.S. unemployment has more than halved since peaking in 2010, thanks in large part to decisive Fed action. Unfortunately, this translated into a mere 2.4% of growth in gross domestic product (GDP) for both 2014 and 2015, according to the latest estimates of the Bureau of Economic Analysis. For 2016, we now forecast 1.8%. Potential U.S. growth is probably quite a bit lower still. The same is true in other developed markets that embraced QE early on. At 2%, growth remains disappointingly slow in the United Kingdom, if judged by historic standards. However, unemployment has fallen to 5.1 %, suggesting there is little slack left in the labor market. It appears that the United Kingdom, just as the United States, is no longer able to sustain the sort of growth rates familiar from previous EFTA01437711 cycles, without triggering inflation. 2 Blanchard, Olivier J., and Summers, Lawrence H., Hysteresis and the European Unemployment Problem, NBER Macroeconomics Annual 1986, Volume 1, pp. 15 — 90. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437712 The limits of monetary policy Amercias Edition I March 2016 6 Since 2009, monetary-policy rates were mostly stuck near zero... 7 6 5 4 3 2 1 0 2007 2009 2011 2013 2015 2005 2007 2009 2011 2013 2015 in % Fed Funds Target Rate ECB Main Refinancing Rate BoE Official Bank Rate BOJ Result Unsecured Overnight Call Rate ... while unemployment swiftly started to decline. 10 11 12 13 3 4 5 6 7 8 9 in % (seasonally adjusted) United States Eurozone United Kingdom Japan Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 What can anyone do? Well, all U.S. monetary policy can do is to wait for the EFTA01437713 economy to heal — and hope that potential growth will eventually pick up again. Over the medium term, we would still expect potential growth to edge a bit higher, as some of the lingering effects of the crisis continue to fade, and productivity and labor-force growth recover a bit. By contrast, there are plenty of things governments (as opposed to central banks) could do. Boosting spending on education, liberalizing labor and product markets, improving incentives in tax and entitlement systems, amongst other measures, come to mind. Talking about "structural reforms" may sound trite, but they remain extremely important. Implementing reforms is easier said than done — just look at Japan and the Eurozone. Politics frequently gets in the way. This has arguably been the story behind the Eurozone debt crisis and Japan's malaise. Japan is now in the 26th year of what was at first called its lost decade. Many of the problems in both Japan and the Eurozone are structural. Monetary policy is hardly the most obvious way of tackling them — as the BOJ itself argued for much of the initial lost decade. Fiscal policy would be a more obvious bet — especially if the money is spent on the sort of infrastructure projects that will actually boost potential growth, rather than on bridges to nowhere. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437714 The limits of monetary policy Amercias Edition I March 2016 7 Central balance sheets as percentage of GDP in % of GDP BOJ 100 120 20 40 60 80 0 2006 2008 2010 2012 2014 2016 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 All of which makes it rather odd that so many hopes should still rest on central banks. After all, Japan already tried QE from March 2001 to March 2006. According to most empirical studies, this was of limited help in either boosting output or inflation. Indeed, it may even have strengthened the performance of Japan's weakest banks — further delaying the necessary clean-up of bank balance sheets. Markets were fairly unimpressed. Japan's initial dose of QE simply seems to have acted as a sedative. One down-side of loose monetary policy — and not just in Japan — is that it can reduce the pressure for reforms. 2. The limits of central banking. So far, we have seen that there is little monetary policy can do to boost long-term growth potential. At most, it might provide breathing space for structural reforms (but with the caveat noted above). For investors, however, a more immediate question is whether central banks are also losing their ability to cheer up markets. Here, the evidence is mixed — and to see why, look no further than at Japan's previous attempt at QE. Japan's structural problems are real enough, but they only tell half of the story. The other half is one of monetary impotence to do even the limited work central banks are usually charged with: making sure that actual economic growth is in line with EFTA01437715 potential growth rates. Central banking can prove tricky enough in normal times. As Rudiger Dornbusch quipped in 1997, "None of the U.S. expansions of the past 40 years died in bed of old age; every-one was murdered by the Federal Reserve."3 at least, central banks have plenty of historic data to rely on. But By contrast, economists looking at Japan since the early 1990s had to go back to the Great Depression to find anything remotely similar. Japan appeared stuck in a liquidity trap, the traditional bogeyman of central banking (see box). Much of the policy response in the rest of the world since 2009 can best be understood as an attempt to avoid such a fate. Central bank balance sheets as percentage of GDP have ballooned BoE BOJ forecast BoE forecast ECB ECB forecast Fed Fed forecast Throughout the developed world, central banks have taken ever more assets onto their balance sheets. Initially, this reflected such programs as the Fed's Term AssetBacked Securities Loan Facility (TALF) in the United States, intended to boost consumer lending in the aftermath of the financial crisis. Similarly, the Eurozone debt crisis caused the ECB's balance sheet to expand, well before the formal adaption of QE. In recent years, balance sheet growth has been strongest in Japan, reflecting its increasingly aggressive use of QE policies. 3 Dornbusch, Rudiger. 1997. "How Real Is U.S. Prosperity?" Column reprinted in World Economic Laboratory Columns, Massachusetts Institute of Technology, December. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to EFTA01437716 change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437717 The limits of monetary policy Amercias Edition I March 2016 8 Liquidity traps, monetary policy and QE Liquidity traps describe a situation where conventional monetary policy has lost its potency. Remember how monetary policy normally boils down to changing interest rates in a timely fashion? Technically, this means buying short-term bonds from the banking sector, reducing short-term rates and paving the way for money creation. By promising to keep buying short-term bonds until the economy has regained its footing, moreover, the central bank will also put pressure on yields of longer-term government bonds. This ideally translates into lower interest rates when a firm was looking to fund risky, longer-term investments, such as building a new factory. Note that a central bank only firmly controls the first step of this process. The rest partly depends on others. Even in normal times, it is rather like a very impressive conjurer's trick, which works best when the audience is willing to play along. In a liquidity trap the central bank loses control even over that first step — short-term interest rates. Since the late 1930s, most economists felt that this was a theoretical, but fairly remote possibility. A liquidity trap requires several unusual things to happen at the same time. First, you need a severely depressed economy — an ailment central banks would normally be able to cure by waving their interest-rate wand. And second, inflation needs to be very low to begin with. That too, should normally not be much of a challenge — in fact, central banks usually worry more about the opposite problem, of inflation being too high. Take both things together, though, and you have every reason to worry. A central bank that has already cut nominal interest rates to zero must face up to the problem that the interest rate wand no longer works. Its first instinct might be to do more of the same, that is to keep on buying more bonds. The trouble is that once nominal interest rates hit zero, households and firms will already have plenty of cash — probably far more than they need for their planned purchases of goods and services. So, if you try to buy even more bonds from them, they will take the cash and simply hold onto it as a store of value. Under these conditions, money becomes a perfect substitute for short-term bonds. At the first glance, it is not clear how printing more money will help in this situation! Why would an economy get so depressed? Well, for one thing, you might find yourself in a vicious circle. Falling prices and weak consumer demand EFTA01437718 discourage investment. This, in turn, means that real interest rates would need to fall for firms to invest in new factories. But with inflation turning more and more negative, zero nominal interest rates will translate into real interest rates actually rising, discouraging investment even more. This, in turn, might make households want to consume less (and save even more).4 Alternatively, the initial source of the problem might be households, who expect real incomes to be lower in the future, due to, for example, an aging population. This appears to have been part of the problem in Japan, where a shrinking working population has existing disinflationary and, increasingly, deflationary pressures. 4 This is broadly the argument of John Maynard Keynes, esp. chapters 15 and 23 of "The General Theory of Employment, Interest and Money.", 1936, Palgrave Macmillan. His followers took a narrower view, looking at liquidity traps mainly by focusing on the zero lower bound of nominal interest rates. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437719 The limits of monetary policy Amercias Edition I March 2016 9 Most recent discussions take a highly accessible paper by Noble laureate Paul Krugman as their starting point.5 The implication of his model is that there is indeed little that conventional monetary policy can do in the here and now. Printing more money to buy more bonds makes no difference. There is a way, however, that a central bank might still work its magic, namely through expectations. This means convincing households and firms that you will not just expand money supply today, but continue to do so tomorrow. If it succeeds, inflation expectations will rise, allowing real interest rates to fall and stimulating investment. Of course, this only shows that monetary policy might work, not that this is the best option, or even a particularly good path out of the liquidity trap. Once interest rates are at zero, short-term bonds and money are close to perfect substitutes. Conventional monetary policy loses much of its potency. Even if a central bank somehow succeeds in pushing nominal interest rates on bank deposits into negative territory (an option section 2 looks at), this would simply make cash even more attractive than bonds as a store of value. So, if a central bank keeps on buying short-term bonds, we would still have the same problem — it would keep on buying, without those purchases having any impact. But what if the central bank starts buying longer-duration government bonds? Couldn't this help by reducing the term premium? And surely, QE might squeeze spreads, either by central banks buying corporate bonds directly or by pushing private investors into higher risk assets? And finally, all this should reduce funding costs for companies building new factories, should it not? Also, might the rise in asset prices of all sorts not make households feel wealthier, boosting consumption? Well, a resounding "Maybe" to all of the above. Something along these lines has happened in practice. Central banks used to be lenders of last resort. Increasingly, they have instead become the buyer of last resort. This certainly worked in terms of reducing longer-term government bond yields — ballooning central bank balance sheets coincided with falling bond yields. EFTA01437720 5 Krugman, Paul R. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap." Brookings Papers on Economic Activity, 1998, 29(2), pp. 137-205. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437721 The limits of monetary policy Amercias Edition I March 2016 10 ECB balance sheet and 10-year Bund yields 3,500 3,000 2,500 2,000 1,500 1,000 500 2006 2008 2010 2012 2014 2016 in billion euros in % 0 Yield 10-year Bunds (right axis, inverted) ECB balance sheet (left axis) 1 2 3 4 5 6 Fed balance sheet and 10-year Treasuries 6,000 in billion U.S. dollar 5,000 4,000 3,000 2,000 1,000 0 2006 2008 2010 2012 2014 2016 Yield 10-year U.S. Treasuries (right axis, inverted) Fed balance sheet (left axis) in % 0 1 2 3 4 5 6 EFTA01437722 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 For such a widely used tool, it is surprising how hard it is to make QE work in theory.6 The trouble is that any such framework must take its longer-term impact into account. Fortunately, central banks not much keener than stage magicians to let you in on the inner workings of their latest creations. As a result, it is fairly easy to figure out what is known — and, more worryingly, what even central banks do not know. We know from empirical studies in the United States, the United Kingdom, and, in recent years, the Eurozone and Japan, that QE "works" in the short term in terms of moving markets, and perhaps, even increasing lending. We have some ideas on why this might be so. It remains unclear, however, how QE will impact inflation, economic activity and asset prices across the economic cycle. From a theoretical perspective, we know that households and firms will try to anticipate future central-bank actions — which risks offsetting much of what the central bank is doing through the channels described above in the here and now. To take the example of the wealth effect, let's say that the Fed buys 30- year bonds today, drives down nominal market rates and thereby increases the nominal value of the longer maturity bonds I hold in my portfolio. On paper, this makes me wealthier. If I am rational, though, I will know that returns on any additional bond investments I make to save for my retirement will be lower. Moreover, if and when QE does its job in restoring full employment, interest rates will increase, so I will face losses in the future. My real wealth, over my remaining life-time, has not really gone up, and there is little reason why I should boost my consumption. Instead, I might even decide to save more! Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, EFTA01437723 opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. 6 As a useful starting point for figuring when central-bank openmarket operations do and do not impact the private sector, see Wallace, N. (1981). A ModiglianiMiller theorem for open-market operations. American Economic Review, 71(3):267-74. EFTA01437724 The limits of monetary policy Amercias Edition I March 2016 11 For QE to have much of an impact, you need to create somewhat ad-hoc assumptions. Translated into plain English, this means coming up with stories for why private investors will not fully adjust their portfolios to reflect recent and anticipate future actions by the central bank. Generally, such stories boil down to different assets not being perfect substitutes for different types of investors. Insurance companies or pension funds, say, might face regulatory restrictions on which assets they can hold. There might be differential information and transaction costs for retail investors. Some investors might invest in certain ways simply out of habit. All of which might be true, but ideally, you would want to have a lot more data before betting economies worth trillions of dollars on it. To his credit, Ben Bernanke, the Fed's chair throughout much of the crisis, has freely acknowledged as much in speeches and in his earlier academic work.7 We would argue that part of the reason the Fed was relatively successful with this policy, was markets were ready — indeed eager — to play along. It is less clear that QE will be as helpful going forward, either in the United States or elsewhere. As the balance sheets of central banks have ballooned, private-sector debts have also been mounting, from emerging markets borrowers to U.S. corporates. In the search for yield, some of the money that actually did find its way into lending will inevitably turn out to have been misspent — perhaps sowing the seeds of the next crisis. 7 See, for example, Bernanke, Ben, "Monetary Policy since the Onset of the Crisis", Presented at the Federal Reserve Bank of Kansas City Economic Symposium, "The Changing Policy Landscape," Jackson Hole, Wyoming, August 31, 2012; http://www. federalreserve.gov/newsevents/ speech/bernanke20120831a.pdf Despite monetary easing, Eurozone lending remains subdued year-on-year change in % 20 EFTA01437725 15 10 5 0 -5 2006 2008 2010 2012 2014 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 2016 Eurozone loans to non-financial corporations Eurozone loans to households Lending never really recovered from the crisis Despite all the efforts by the ECB, loans to the business sector of the Eurozone remain weak. In part, this probably reflects the fact that troubled banks, especially in Southern Europe, are not fully transmitting monetary loosening to their clients. A bigger problem is probably demand for business loans remains weak, reflecting subdued growth in several Eurozone economies. Loans to households are slowly rising. Overall, however, QE has not proven very effective in improving lending. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437726 The limits of monetary policy Amercias Edition I March 2016 12 And, we are hardly alone in this assessment. As Stephen Williamson, Vice President at the Federal Reserve Bank of St. Louis, noted in a recent review, taking a broader historic perspective: "The theory behind QE is not well-developed ... Evidence in support of Bernanke's view of the channels through which QE works is at best mixed... Much of the work on the quantitative effects of QE consists of event studies, whereby researchers look for effects on asset prices close to the date of an announced QE intervention. ... All of this research is problematic, as it is atheoretical. There is no way, for example, to determine whether asset prices move in response to a QE announcement simply because of a signaling effect, whereby QE matters not because of the direct effects of the asset swaps, but because it provides information about future central bank actions with respect to the policy interest rate. Further there is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed —inflation and real economic activity." 8 Given such doubt, it is no wonder that the Fed is hoping for a return of more normal times — when it could count on well-understood tools to do the job. 3. Consequences for investors In 1976, the economist Robert Barro argued that an activist monetary policy gains much of its effectiveness from confusing people, clouding signals to market participants. That can secure tranquility for a while and perhaps provide a temporary boost to output. However, that stability comes at the cost of even greater variance later on.9 Eventually, you might expect inflation, GDP and also financial markets to become more volatile. Given how much QE appears to have relied on market expectations, it is hard to say if such a tipping point has already been reached. Over the past year, the investment environment has clearly been getting trickier. In the past, correlations across different asset classes were generally such that you could reap decent returns without taking too much risk, using diversification effects to mitigate the downside risks. Now things are different. EFTA01437727 This is especially true if we compare the period between 2010 and 2015 with the recent market turmoil. Lately, many unusual correlations have cropped up that you might not have expected. For example, major equity indices have tended to move in sync with the oil price. This might seem justifiable for the S&P 500 Index, but is less understandable for the German Dax, which does not include a single major oil producer. In any case, correlations between oil and the S&P 500 Index have historically tended to be negative, which also makes more economic sense. Worse still, many old correlations have been swept aside. Volatility is increasing. 8 Williamson, Stephen D., "Current Federal Reserve Policy Under the Lens of Economic History: A Review Essay", Federal Reserve Bank of St. Louis Working Paper Series, Working Paper 2015-015A, pp. 8-9. https://research.stlouisfed.org/ wp/2015/2015-015.pdf 9 Barro, Robert J.: Rational Expectations and the Role of Monetary Policy. Journal of Monetary Economics; pp. 1-32, January 1976; Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437728 The limits of monetary policy Amercias Edition I March 2016 13 Historical relationship between the Dax and government bonds Correlation Daxl vs. Bunds2 -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 08 1 0 2000 2002 Dax Price Index 2 2004 (monthly data, 12 month rolling) Old correlations are breaking down Until recently, investors could count on returns from equities to be negatively correlated with returns on government bonds for most of the time. As the chart comparing the German Dax and 10-year Bunds illustrates, this relationship was not stable, but the tendency was clear. In recent months, by contrast, correlations have turned positive This meant that adding government bonds to an equity portfolio has become a much less effective tool to reduce the overall risk profile. 2006 2008 2010 BofA Merrill Lynch 7-10 Year German Government Index 2012 Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 03/2016 1 2014 2016 These are early signs that QE euphoria has come at a cost. It may have assisted generating high returns in financial markets in recent years, but investors should expect leaner times ahead. In the meantime, there are likely to be dramatic swings — in both directions. Over the medium term, it appears likely that confidence in the ability of central EFTA01437729 banks to stabilize financial markets will continue to erode. Just because this is likely to happen eventually, however, does not mean we are quite there yet. Central banks still have options — and willingness too, it would seem, to creatively use any readily available tool remaining. However, betting on their magic touch is getting riskier. Look at how last December, the ECB caught investors on the wrong foot. Markets had grown used to its President Mario Draghi over-delivering. Instead the ECB underwhelmed in the short term. It only tinkered on the edges of its existing QE program, focusing instead on cutting (its already negative) deposit rate further in the wake of similar decisions in several smaller European economies. Sweden, Denmark and Switzerland have increasingly relied on negative interest rates to discourage capital inflows (see box). Beyond the zero bound Negative interest-rate policies (NIRP) have always been controversial in the academic community, and even less systematic research has been done on their effectiveness than with respect to QE. We believe, their growing use raises at least three issues: 1. What's the point of negative nominal interest rates? The answer to this question should be clear from section 2. If they can be implemented without too many detrimental side-effects, NIRP offer a neat way out of the liquidity trap. Monetary policy regains its power to push real interest rates lower, even in a low-inflation environment. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437730 The limits of monetary policy Amercias Edition I March 2016 14 However, things get somewhat messy when you think about the practicalities. So far, negative interest rates are only charged on balances of commercial banks with the central banks. Commercial banks have been reluctant to pass this cost on to their clients, so most of the private sector, including practically all individual savings accounts, is not charged. This, in turn, means two things. First, households are shielded, so lower interest rates will not have an impact on household behavior (encouraging current consumption, say, by discouraging saving, or prompting households to purchase riskier assets). Second, bank profitability will suffer. 2. What's the evidence so far on the impact on banks? In Sweden, Denmark and Switzerland banks have coped reasonably well with negative interest rates, in part because their domestic banking markets are quite concentrated." This allowed the top two or three key players to make up for the shortfall by pushing up profits on other products. For example, Swedish banks have been able to protect their net interest margin by increasing mortgage loan rates to offset charges on deposit. The problem is that, first, this means that the NIRP results in tighter, rather than looser financial conditions. Second, it would not work in other, less concentrated markets. And third, and perhaps most troubling for the ECB, it means NIRP will have a differential impact in different Eurozone countries, depending on the degree of concentration in the local banking market. 3. How low can central banks go? Therein lies another problem. After all, there was a reason why most economists were doubtful of attempts to push interest rates below zero. Reduce the interest rates too much, and the private sector might simply withdraw their bank deposits and hold the money in cash. Of course, there are some costs to storing cash, with some estimates at 20 basis points (bps), and some a bit higher. However, the ECB is already in the lower range of such estimates. Moreover, comparisons with credit-card charges of several hundred bps are somewhat flawed: a large chunk of cash deposits are probably held as a store of value, rather than with any immediately looming payments in mind. To implement negative deposit rates anywhere near that level, you would probably have to introduce a time-varying fee of some sort on (physical) cash of the sort initially proposed by the German merchant Silvio Gesell 100 years ago. No country has since tried to implement 'Gesell money' and political obstacles look EFTA01437731 sizeable. The evidence so far suggests that when they work, the effect from NIRP is mainly from driving down exchange rates rather than by stimulating lending. For small open economies, this might even be part of a "foolproof way" to escape the liquidity trap and deflation. The idea was for the central banks to give a commitment to higher future price levels, concrete action, such as a currency's sharp depreciation, to demonstrate that commitment, and an exit strategy of when and how to get back to normal.10 In a small open economy, such as Sweden, a currency devaluation can go a long way in rekindling inflation. Unfortunately, using devaluation is a lot harder to manage in large economies, such as Japan and the Eurozone. 10 Svensson, Lars E.O. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others." Journal of Economic Perspectives, Fall 2003, 17(4), pp. 145-66 Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437732 The limits of monetary policy Amercias Edition I March 2016 15 Again, it is Japan that provides the most cautionary tale on monetary impotence. In January it took markets by surprise by implementing a NIRP of minus 0.1%. The system was structured in three tiers, to reduce the impact on bank profitability, but nevertheless hit bank share prices hard and reinforced broader market weakness. This, in turn, put upward pressure on the yen, precisely the opposite of what the BOJ had been aiming for. NIRP has suddenly brought home one implication of unconventional measures for households: it is supposed to work, in part, by depressing the future value of their savings. To a trained economist, there might not seem to be much of a difference whether that wealth transfer takes place through inflation eroding nominal returns or NIRP. To households and companies, it probably does — which risks further eroding confidence in central banks being able to "fix" the problem. Asset-class implications: 1. Currencies: Expect more currency volatility, sometimes in surprising directions, that defies what policy makers have had in mind. The underlying driver of this volatility remains divergence in monetary policy between the Fed, wanting to get back to normal, and others, particularly the BOJ and the ECB relying on increasingly unfamiliar tools, such as NIRP. We believe eventually, this should translate into a strengthening U.S. dollar. 2. Bonds: QE has pushed an ever growing number of sovereign bonds into negative territory. Effectively, this has destroyed positive, nominal returns on "safe" government bonds, a key element which diversified investors have long been able to rely on. This means risk-free rates can no longer serve as a portfolio cushion in a diversified portfolio. For sovereign bonds, it is worth keeping in mind that these too are far from risk-free. If you think that QE will eventually succeed in boosting inflation, rates have to go up. Holders of longer maturity bonds therefore face significant duration risk. Against this background, we believe investment- grade debt and also high yield are probably among the more attractive alternatives. EFTA01437733 3. Equities: For U.S. equities, most recent concerns have centered around recession fears. However, this is no longer the only risk. Continuing solid U.S. economic performance, resulting in swift further interest-rate increases, would also be worrisome. Either way, U.S. margins have probably peaked. U.S. strength would probably be reflected in consumer spending holding steady on the basis of rising wages and continuing employment growth. This could put pressure on earnings. More broadly, the above discussion suggests that further monetary adventures in other parts of the world, such as negative interest rates, come with risks attached — both in terms of their direct impact (on bank profitability, for example) and by increasing the scope for policy errors. Risk premia might rise. Past performance is not indicative of future returns. No assurance can be given that any forecast, investment objectives and / or expected returns will be achieved. Allocations are subject to change without notice. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect.The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. EFTA01437734 The limits of monetary policy Amercias Edition I March 2016 16 4. Policy challenges a