Wanted: rehab for central banks

Once the pandemic is under control in a few months, the economy will get a huge boost. This is largely due to all the measures taken by central banks. It will soon become clear what price tag is attached to that support.

The interest on savings is alarmingly low, but on the other hand, you pay a pleasantly low interest rate on your mortgage. There is, however, an important difference between the two. The interest on savings is linked to the interest that banks receive when they deposit money at the ECB. Since 2019, they have already had to focus on this by 0,5%. In that respect, a savings rate of 0% is not so bad. However, interest rates for mortgages are linked to those in bond markets. The interest rate for Dutch 10-year government bonds is also negative: -0,28%.

What happens if interest rates rise?
But in Europe and many regions, the bond markets are showing significant gains. And because prices there are determined by supply and demand, central banks have little influence on this. Although? Already during the financial crisis of 2008, central banks started buying government bonds en masse. This causes the prices of those loans to rise, which leads to falling interest rates on the bond market. This low interest rate makes it easier to finance investments, giving the economy a boost. However, there is a price tag to the buying strategy of central banks.

Pandora's Box
It is a lot easier to start buying bonds than to suddenly stop buying them. Since central bank policies have already fueled fears of inflation, there is a danger that bond market yields will rise rapidly. Although the Federal Reserve has cautiously reduced its buying policy in recent months, the major central banks have not been able to close Pandora's box again. In fact, the Bank of Australia opened that box even further this week.

Buying Addiction
That signal echoed on financial markets worldwide. Prices of equities and other risky assets everywhere bounced, as this was a clear signal that central banks are willing to go to great lengths to keep bond market yields low. The buying addiction of central banks also has an impact on the currency world. For example, the ECB has hinted in recent days that it will not accept that bond market yields are rising too far. Immediately afterwards, the value of one euro briefly dropped below $1,20 for the first time since early February.

Currency War?
The purchase policy is therefore not only a means to give the economy a boost. But also to give the international competitive position a boost by pushing down its own currency. Investment bank Commerzbank hinted earlier this year that a currency war is coming. And Chinese regulators warned this week that all sorts of speculative bubbles could be created by central bank policies. It promises to be an interesting time once the virus pandemic comes under control and Pandora's box has to be closed.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

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