"I am a Fiscal Hawk” Vinod Khosler
After a slow start to the week, activity and intensity picked up yesterday with the scheduled monetary policy announcements from the Federal Open Market Committee (FOMC) and the Bank of Japan (BoJ). While market’s focus on the central banks’ words and actions were acute, there were implicit and explicit signals from both that the marginal efficacy of monetary policy is diminishing (or even diminished). From our perspective, this signifies an important transition for the global economy, a transition away from monetary stimulus towards fiscal stimulus and structural reform. If fiscal stimulus is bold and appropriately targeted then it could also signify the return of business investment, growth impetus and ultimately inflation.
If our view is right and that we are at the start of a process of transition in the global economy which could presage a return of (potentially significant) inflation, then the medium term forecasts of all major central banks, and the market for growth, inflation and financial (and real) assets would have to change (perhaps significantly). This is a theme that we intend to monitor and communicate over the medium term. Today, however, we discuss the detail of this week’s monetary policy meetings and thus the near term implications as we see them for financial markets.
"Take a Rover 25 and glue a spoiler to the back of it” Jonathan Ferro
First up was the Bank of Japan. Earlier in the week we suggested that there was a risk of a lower policy rate and a further move away from QQE, towards interest rates as the main policy tool. What we actually got from the Bank of Japan was "QQE with yield curve control”. While this may sound like an optional extra for a Ford Mondeo, it is potentially a very interesting (if subtle) development as the BoJ move away from a fixed expansion of monetary base and use the shape of the yield curve as a policy tool.
In addition to the QQE with curve control (scrapping the average maturity target of JGB holdings and targeting a positive 10 year JGB yield ), the BoJ raised their inflation target. In essence the implied shortening of duration on bond holdings and implicit steepening of the curve could both be seen as a tightening of monetary policy and are likely explicitly aimed at restoring banking and insurance industry stability. Raising the inflation target (particularly when they have singularly failed to hit the previous, lower target) reaffirms a strong commitment to higher inflation and is the core easing measure - that is, providing it generates higher market inflation expectations.
However, judging solely by the price action the market is yet to be convinced that the BoJ has altered the likely path of inflation, growth or interest rate trajectory by its actions yesterday. As per our opening discussion, a return to inflation in Japan is increasingly reliant on Arrow 3 structural (or fiscal) reform.
"Audacity augments courage; hesitation, fear” Publilius Syrus
In the US, we had cautioned that the market was perhaps too complacent in its view of Fed inaction, and a dovish statement. Despite a modestly hawkish voting composition, such complacency, however, was not punished. Whether or not the caution of the FOMC is a function of the recent rise in Libor rates (a technical response to money market reforms set to come into place on October 14th), the upcoming uncertainties surrounding the market reaction to the Presidential race, or even global economic or geopolitical risks, the actions of the Fed continue to disappoint the hawks, flatten the yield curve and buoy equities and risk assets..
Balancing the statement that the Fed will "Wait, for the time being, for more evidence” Chair Yellen stated that continued economic momentum at the current pace and "no new risks”, would justify a hike this year (December is the only likely option). Esther George was joined by two further voting members (Rosengren and Mester), dissenting in favour of a rate hike, strengthened this sentiment.
The damage to interest rate expectations, and the USD, however, was done by the lowering of the longer term rate projection (or r*) to below 3%. While this was something that we discussed earlier in the week, and was expected by many, its announcement drove longer dated Treasury yields lower, and the curve flatter.
Flattery will get you nowhere - proverb
This is a key area of difference in the (central bank guided) market response to yesterday’s monetary policy meetings. In the US, ‘wait and see’ in the near term and a lowering of rate expectations further out, drove a flatter curve that weakened the USD across the board. Kuroda on the other hand was explicit in stating that "Excessive flattening of the yield curve may be negative for the economy”, and the anchoring of the 10 year JGB yield in positive territory, ultimately drove the JPY higher. We would agree with Kuroda’s yield curve sentiment and would expect major central bank yield curve flattening to begin to re-steepen going forward.
While it can be argued that medium term inflation differentials will continue to favour further JPY gains, real yield differentials could well underpin an albeit volatile USDJPY in the near term. If we are right about the return of inflation, then this could bring about a new wave of JPY weakness.
"The golden rule is that there are no golden rules” George Bernard Shaw
Trading sessions so far this week have been more akin to the warm up sessions for athletes stretching their legs and contemplating strategies than actually competing. With an extremely light data calendar so far this is perhaps excusable and, with imminent and dominant central bank policy meetings in Japan and the US tomorrow, understandable.
In Japan, we await not just a monetary policy decision, but the release of a report into the efficacy of the Bank of Japan’s policy to date (sadly stopping short of questioning the concept of inflation targeting in favour of questioning the success and efficacy of its current, and potential future policy mix in attaining it). In the US, the central focus is very binary - will the Fed raise rates or not. In reality, however, it is never quite as simple as that.
"There are two classes of forecasters: those who don’t know, and those who don’t know they don’t know” J K Galbraith
A few weeks ago New York Fed President, William Dudley, stated that the market was "too complacent”, hinting that monetary tightening was closer than (the then) current market expectations. Since then the retail data has implied that consumer spending is likely to slow (perhaps significantly) in Q3, private fixed business investment continues to decline and recent manufacturing and service sector survey declines suggest a less than robust level of current corporate activity - despite continued labour market strength. This ebb of US economic momentum has led markets to price a less than 20% chance of a rate rise tomorrow. Note that since 1999, the Fed has not increased rates when market pricing has been less than 80%.
Furthermore, tomorrow the FOMC will also be providing updates of its US economic projections and interest rate forecasts that will extend into 2019. Within this it is likely that the average of the long term ‘dots’ will fall below a rate of 3.0%.
However, we like Mr Dudley would argue that the markets are indeed likely too complacent with respect to the Fed (though the removal or lowering of the concentration of the ‘dots’ implying a rate rise in 2016 would counter this argument). The recent rise in front end US Libor rates, ahead of money market reforms that come into place on 14th October, already represents an implicit tightening. While we agree with the broad consensus that there will be no change in rates at tomorrow’s meeting, it is likely that the FOMC will want to keep December ‘open’ as a possibility for the next step of monetary normalisation. Facilitating that would likely require a statement that is at the hawkish end of expectations.
It is also possible that the Fed outline a plan to halt the reinvestment of portfolio income (either immediately, or at some point in the future). Any suggestion of which will likely give real and nominal US yields a slight upward bias and that in turn should translate into a slight upward bias for the USD.
"The longer the excuse, the less likely its the truth” Robert Half
In Japan, complacency is also apparent. Market expectations have converged on ‘unchanged’ at least as far as the immediate policy response is concerned. We, however, maintain the view that there is risk of a further push into negative territory for interest rates. There is little upside in Kuroda taking his foot off the gas at this stage and, as the ‘review’ of the efficacy of the BoJ’s monetary response stops short of questioning the target itself, thus we see little chance of a change of tack - other than potentially the BoJ increasing turn their attention towards (more) negative rates as a policy stimulus rather than further QQE.
"The contour eludes me” Paul Cezanne
Earlier in the week we suggested that the chances of further accommodation from the BoE this week were "very low indeed” and that they would likely reassess the situation at the November ("Super Thursday”) meeting. At this point they will be furnished with updated projections from the Quarterly Inflation Report (QIR). While in essence this was the outcome, there were a number of interesting points to note.
The BoE acknowledged that "some near term indicators had been better than expected” and as a result that the slowdown in the second half of this year "may be less severe” than it had forecast at the August inflation report. However, while acknowledging this, the committee was clear in the statement that there had been "no new information since the August Inflation Report relevant for the longer term prospects of the UK economy” and that ultimately, the MPC’s view of the "contours of the economic outlook are unchanged”. Furthermore, should the August outlook be reaffirmed by the November QIR, then the "MPC majority expect a rate cut”.
This sentiment is at odds with that of the market prior to the meeting which had edged towards expectations of a more hawkish response from the MPC, in light of the rebound in composite output expectations indices (and the already significant monetary easing in August). The MPC were also clear to point out that the impact of their package of measures "led to a greater than anticipated boost to UK asset prices”. Also, in a further defense of the MPC activism, Carney’s decisive leadership at a time of political and economic instability helped shield the UK economy and restore confidence.
Threadneedle Street to Downing Street
As we discussed earlier in the week, however, the debate (globally, not just in the UK) is increasingly transitioning towards fiscal stimulus, and away from (most specifically non-standard) monetary stimulus. In this regard, ECU global Macro Team member Charles Goodhart summed up our sentiment in relation to a November rate hike yesterday when he stated "it’s clear that policy is shifting from monetary to fiscal. It’s going to be fiscal policy driving the economy. And the MPC are not going to know when they next meet in November” what fiscal plans will be announced in the Autumn statement 3 weeks later.
A further UK rate cut is still a possibility in December in our opinion. However, the trajectory of UK activity and indeed GBP is likely to be increasingly driven from Downing Street and not Threadneedle Street for the near term.
"I’m the worst Bond, according to the internet” Roger Moore
With very little in the way of data (ex US CPI) for the rest of this week, it is worth mentioning the emerging dominance of fixed income sentiment and the fluctuation thereof as a leader of the broader financial markets. In essence bond yields have resumed their move higher this week after their rebound from the lows in July (UK Referendum aftermath).
Central banks are fearful of the effects of protracted periods of negative rates, and increasingly aware of the dangers of yield curves that are low and flat at the same time. Growing market expectations are that the impending BoJ monetary policy review will change the emphasis back towards (even more negative) interest rates and away from QE purchases as the primary monetary policy tool. These interpretations have led to steeper yield curves - not just in Japan, but globally - and this is a theme which we feel will become increasingly dominant going forward.
"European Union still does not have enough union” Jean-Claude Juncker
In the period since our last post there have been several macroeconomic and geopolitical events worthy of note. However, such developments have failed to produce any clarity at global or even national level as far as economic progression or perhaps more pertinently the progression of global monetary policy. Last week saw three major central bank meetings: the Bank of Canada surprised on the dovish side, the ECB surprised on the hawkish (or at least less dovish) side and the Reserve Bank of Australia surprised by leaving the statement largely unchanged from the previous month. What is the real state of the union?
"Experts often possess more data than judgement” Colin Powell
On the data front, the US economic recovery ebbed, with notable weakness in surveys of manufacturing and service sector activity, and a more moderate pace of payroll growth (still comfortably strong enough to see continued tightening of the labour market). In the UK, the backdrop was the polar opposite, as surveyed activity rebounded strongly. While we remain positive on the UK economy relative to both expectations and its peers, we would caution against extrapolating the recent rebound, however, as a significant proportion of the rebound is likely to have been delayed activity from the pre Referendum uncertainty period.
Sticking with the UK and US, the monetary policy progression has been equally uncertain. Prior to the recent, more pedestrian US data, it appeared that September was increasingly likely. In fact comments from Boston Fed Governor (non-voter) last week, suggesting that current low rates increased the risk of the Fed being behind the curve going forward, highlighted the sensitivity of both stocks and bonds to the prospect of eventual monetary normalisation. Lael Brainard (voter), however, swiftly gave the opposing view, that the risks of raising rates too soon were greater than those posed should inflation surprise to the topside. Market expectations of a rate rise next week from the FOMC are now around 25%. We would expect that such low market expectations (with the blackout period removing the option to ‘talk up’ expectations) preclude a rate hike, particularly in light of the price action in equity and bond markets on Friday.
In the UK, with the BoE having acted swiftly and aggressively in the aftermath of the UK vote to leave the EU, expectations of further monetary accommodation at this week’s meeting have waned with the rebound in the data (admittedly survey or sentiment based data). We view the chances of further accommodation from the BoE this week as very low indeed, given the potential difficulties in longer dated gilt purchases under the new QE programme and the proximity of the Bank Rate to the self proclaimed lower bound. We would anticipate an unchanged verdict from the BoE, at least until the Inflation Report (and new projections) in November, while the macroeconomic backdrop remains significantly more stable than many had feared.
Indeed, with currency depreciation pushing up import prices, money supply (M4) growth trending higher, and wage growth (albeit modestly) picking up, a case could be made that the next move in rates is in fact up. That is not to say that in the near term Carney et al. won’t play down the rebound in economic activity measures and play up the medium term risks of Brexit, as its implications become better understood.
"I love argument. I love debate” Margaret Thatcher
In a broader global context, while the intellectual debate seems to be moving away from ever deeper reliance on (non-standard) monetary accommodation, market focus and volatility remain acutely correlated to monetary expectations.
Bloomberg posted a story overnight reporting that a professor of psychology at Waseda University in Tokyo (focussing on decision theory) is recommending encouraging younger consumers to spend more, by providing them a "financial and emotional cushion”. While this is a different expression of radical policy (and one which we expect to have very limited attention applied to it) it highlights the current policy debate. As fears of secular stagnation germinate, the arguments over the real neutral rate of interest continue (R-star in terminology as recently discussed by Fed Williams). Against this backdrop, the Bill Gross comment that "capitalism does not work at zero interest rates” is likely increasingly weighing on policy makers’ minds.
"Where do we go now?” Guns N’ Roses, Sweet Child of Mine
At Jackson Hole this weekend, the core debate entitled, "Designing Resilient Monetary Policy Frameworks for the Future”, would perhaps be more aptly named "Has anyone got any good ideas?”. Amid a global contagion of low interest rates, low inflation and low growth, central bankers are seemingly becoming more attuned to the hidden costs of zero (or negative) interest rates. Despite the fact that firms have access to record low funding levels, the very same yield curve move has led to a near doubling of the cost to fund pension liabilities. The move has widened inequality, or the wealth gap, and raised questions of all (percentage) fee-based businesses. As Bill Gross said recently, "Capitalism does not work at zero interest rates”, a sentiment with which we would wholeheartedly agree.
Current extreme monetary activism was intended to give a positive shock to national and global economies. The problem is that the longer this monetary ‘medicine’ is taken, the lower the benefits and the higher the risks. Ironically, the focus of the broad financial markets today is on any indication from Janet Yellen about the timing of the next rate rise, when in all likelihood, any hawkish rhetoric is likely to be accompanied by (and essentially negated by) indications of a lower equilibrium level for real interest rates
The highlight for the rest of the weekend is a "General Discussion” panel tomorrow involving Benoit Coeure of the ECB and BoJ Head Haruhiko Kuroda. I for one am hoping that someone at Jackson Hole does have a good idea.
"Progress is man’s ability to complicate simplicity” Thor Heyerdahl
Since we last wrote, markets have been very quiet as the summer holidays enter their peak and the global data calendar remains thin or, as in the case of US and UK GDP prints for Q2, backward looking and less relevant than future policy expectations. There has, however, been some increased rhetoric from OPEC and individual nations about a push to attain a more sustainable price level. Earlier today the OPEC Secretary General claimed that there is an "increased understanding among OPEC members for a move to manage production”.
The data that we have had has shown: a strong bounce (biggest in 3 years) in UK consumer confidence after the Brexit armageddon fears recede, in addition to further signs of consumer resilience in retail sales strength; improvements in the services and manufacturing PMI’s in the eurozone, married with falling consumer confidence; a big jump in US new home sales in July and; an interesting contrast in the Q2 GDP breakdown between Germany and the UK, where German figures show that the 0.4% q/q was largely a function of government expenditure at the expense of business investment and domestic demand, and the opposite was true of the UK’s 0.6% q/q.
"The suspense is terrible. I hope it will last” Oscar Wilde
The old equity market adage "Sell in May and Go away. Come back after Labor Day”, would not have been a fruitful strategy this year, with US markets rising between 4 and 8 percent since the end of May. However, with a long weekend in the UK this weekend and the long Labor Day weekend in the US the following week, we would anticipate this period being a significant watershed for the resumption of liquidity, participation and correlation of markets and asset classes (in line with economic fundamentals) - factors which have unreliable at best for a long while, and exaggeratedly so over the summer months.
Over the rest of Q3 we expect economic fundamentals to reassert themselves on both asset class correlations and market trends. The tone that Janet Yellen sets this afternoon may well be an early warning sign for the direction of trends, but we would caution against a short term focus on the timing of the next rate hike over the more significant implications on the pace of tightening and the medium term equilibrium level of real rates.
Either way, we feel that global monetary policy is at its base or at least in every practical sense, exhausted in its usefulness. As the Jackson Hole meeting searches for any good ideas on monetary policy, the broader focus of global stimulus is likely to increasingly turn to fiscal and structural measures. While the longer term implications for global growth on this front are positive, we would expect the transition away from monetary stimulus to generate some significant themes in FX markets and to be increasingly negative for both equities and bonds.
"It seems the brighter you are, the deeper the hole you get into” Tuesday Weld
Over recent weeks we have been discussing the progression and evolution of global monetary policy. As standard monetary policy approached its lower bound, many global central banks expanded stimulus through non-standard measures, some of which (such as quantitative easing, or QE) have been used so extensively over recent years that they would likely now be considered ‘standard’. Yet, in the quest for attaining the magical 2% inflation target, many global central banks have pushed the envelope even further through negative interest rates, corporate bond buying and even direct purchases of equities or ETF’s.
Taking a step back from the near term struggle for central banks to attain their respective inflation targets, we retain a high degree of skepticism about the efficacy of many ‘non-standard’ monetary policy tools. As we contemplate how the history books will reflect such monetary activism (not as highly as those involved may like, we fear), it is perhaps not surprising that global central bankers are taking time, amid continued persistent low growth and low inflation, to review their policy efficacy.
"What happens to the hole when the cheese is gone” Bertolt Brecht
Bank of Japan governor, Haruhiko Kuroda, explicitly ordered an "Assessment of policy effectiveness” to be completed by the next BoJ monetary policy meeting on the 21st September, and we would expect that a number of other global central banks are undertaking a similar exercise (publically or not). This year’s global central bankers ‘off-site’, at Jackson Hole, entitled "Designing Resilient Monetary Policy Frameworks for the Future”, will likely constitute a high level head scratching event over the current issues: low inflation and low growth, and perhaps most importantly, the possible change in their relationships and interactions.
In reality, however, the likelihood of any break away from traditional central bank inflation targeting any time soon is negligible. Instead the Jackson Hole weekend will be the focus of markets purely with the aim of gauging the near term policy inclinations of the array of attending central bankers - most notably Janet Yellen.
"A mouse never entrusts his life on just one hole” Plautus
Yellen speaks late Friday afternoon (BST), and amid a recent ebb back towards the hawkish end of the monetary spectrum, we would suggest that the risks are that Yellen leaves the door open for a September rate rise, with a narrative of the (albeit slow) progression in jobs and (albeit fairly pedestrian) growth. It is also likely that the broader market will be expecting the Fed to once more err on the side of caution while inflation refrains from troubling the 2% target. Thus the bar for a hawkish surprise in terms of near term action is likely quite low.
However, it is also likely that Janet Yellen conveys the message that the longer-term trajectory for interest rates is (once again) shallower than previously thought. Thus, even the prospect of a near term rate hike from the Fed could end up being USD negative and equity supportive if expectations for the equilibrium level of rates are dragged ever lower.
"In trying to scramble out of a hole, it sometimes digs deeper” Wellington Mara
In the UK, the efficacy of monetary policy is being tested more explicitly, as the BoE’s latest foray into asset purchases have not exactly gone according to plan. At its first attempt, the BoE’s reverse auction failed to buy the requisite amount of bonds. Yesterday, in its third open market operation, the BoE was forced to pay a premium on the debt, once more due to low supply, driving prices sharply higher likely unsettling an already nervous market.
The implications of the struggle for the BoE to enact its pre-announced monetary policy actions are not necessarily clear, as far as rates and GBP are concerned. Carney et. al., however, may well be hoping for a continuation of stronger than expected post-Brexit economic data as an excuse to abandon the latest round of QE.
With a very light data calendar, FX has been relatively quiet this week, however, with a number of speakers from the BoJ to the BoE, ECB and of course the Fed, we would expect that Friday, ahead of a bank holiday in the UK on Monday, will bring a sharp uptick in volatility.