The global markets have responded favorably to two global monetary policy developments that occurred this week.
In his comments on Thursday (Oct. 22), European Central Bank (ECB) President Mario Draghi made it clear that the ECB is prepared to undertake further stimulus in a number of ways, if necessary, to meet growth and inflation targets.
Although ECB President Draghi did not announce further easing, growth and inflation are still a concern for the ECB. Draghi stated that monetary policy will be re-examined at the December ECB meeting. He also said that the Governing Council is willing to act by extending and expanding quantitative easing; changing the composition of purchases and by cutting the deposit rate, if necessary, to help the central bank reach its growth and inflation targets.
Another rate cut in China
The other important policy announcement this week came from China, where its central bank, the People's Bank of China (PBoC), cut one-year deposit and lending rates by 25 basis points (bps) to 1.5% and 4.35%, respectively. 1 The reserve requirement ratio (RRR) was cut by 50 bps for major banks.1
With China's monetary authorities seeking to reduce lending rates and spur growth, this latest rate cut represents the sixth such reduction in interest rates since November of last year.1
We believe that in an environment of low global growth, this stimulus and easing stance should be relatively positive for risk assets, such as credit assets. However, we remain cautious that market sentiment could reverse quickly in a scenario where divergent global economic trends and policy generate renewed volatility.
As the US prepares to raise interest rates at a time when other major economies are simultaneously cutting rates, we believe we could return to a strong dollar environment, tighter funding conditions and higher levels of financial market volatility.
With that, we are attentive to two potential risks that might cause a shift in positive market sentiment:
Financial market volatility picks up, driven by US Federal Reserve interest rate hikes that occur perhaps quickly or ahead of market expectations, boosting the dollar.
A pick-up in volatility in Chinese financial markets, with renewed pressure on the Chinese currency.
We believe China is one of the largest factors currently impacting global risk assets. We will be watching the Chinese currency carefully, tracking capital inflows and outflows, as well as possible government intervention in the currency market. If China is able to ease policy and support growth, while keeping the currency stable and volatility low, we believe this would likely be positive for risk assets and market sentiment.
On the other hand, if easing policy in China creates renewed pressure on the currency and an increase in capital outflows, we could quickly shift into a negative risk asset environment. We will be monitoring these potential catalysts carefully.
1 Source: Wall Street Journal
Dovish refers to an economic outlook which generally supports low interest rates as a means of encouraging growth within the economy.
A basis point is one hundredth of a percentage point.
The reserve requirement ratio is a central bank regulation employed by most, but not all, of the world's central banks, that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves (rather than lend out).