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Monetary policy has been in an easing phase since the Fed’s first rate cut in July 2019, with the policy – rate staying at the zero bound since March 2020. Financial conditions have eased globally, touching historic lows, with pandemic – induced peak quantitative easing (QE) and other emergency stimulus injecting significant liquidity into the system.
With the rollout of mass vaccinations against COVID-19 and a seemingly robust recovery of the economy, markets are anticipating a reversal in monetary policy from one of accommodation to tightening, partly as a countermeasure to the growing concern about rising inflation. Yet central banks are still pursuing a lower-rates-for-longer policy, with the Fed indicating that it will maintain the low policy rate until 2023. With the significant build-up of central bank balance sheets, any explicit tightening through policy rate hikes is likely to
be gradual, as QE tape ring and balance sheet contraction may first lead the way.
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The stance of monetary policy is difficult to judge from official policy rates when the latter is constrained by the lower zero bound. Our analysis of shadow rates, however, indicates that monetary easing may have bottomed out, with a new tightening phase underway. After falling precipitously since July 2019, the cumulative decline in short rates bottomed at about -7.9% at the end of May 2021 (from the tightening peak of 2018), which is comparable to the level of easing (-8.5%) witnessed in the post-GFC easing phase of November 2013 (left-hand figure below). The transition from an easing phase to tightening coincides with increased anticipation of pandemic QE policy tapering.
Equity strategies respond to changes in monetary policy. While periods of loose policy coincide with recession and poor economic growth, tight monetary policy generally indicates strong economic prospects. In recent monetary cycles, broad equity markets have been
more buoyant during periods of tightening than periods of accommodation, with aggressive growth-oriented strategies generally faring better during periods of rate hikes (right-hand figure below).