The Federal Reserve is likely to opt for more inaction and the Bank of Japan could double down on negative rates.
Investors’ best guess of what the BoJ and Fed will decide follows a fraught few weeks in global markets that link directly to monetary policymakers’ aggressive efforts to stimulate economic growth. Results have been mixed-to-disappointing, and some of the fall-out has even left central banks at odds with their own ‘price stability’ remits.
The latest example was a sudden revival of benchmark bond yields across the German and Japanese curves which lifted Japan’s 30-year paper from almost zero in July to 0.55% last Friday. Rising yields in the past signified expected lower demand for government borrowing and in turn, improving economies.
But the speed and volatility of the yield jump, accompanied by the VIX volatility index’s biggest rise since June on 9th September, tells us the gyrations don’t signal increased risk appetite.
Fear and confusion are likelier explanations.
As much as investors fear the end is nigh for the Fed’s ‘lower-for-longer’ regime, anxiety has also emerged on the Bank of Japan’s (and the European Central Bank’s) flood of cheap money.
The chief worry is that huge asset purchase programmes will run out of assets to purchase before they reach their goal of rekindling inflation.
The Government of Japan’s Bank of Japan
There’s more urgency in Tokyo.
Having hoovered up 80 trillion yen ($775bn) a year of government bonds for less than two years, the BoJ already owns around 40% of Japan’s official debt. Squabbles about how effective the outlay was—core inflation recently slipped back below zero—have split BoJ rate setters.
Japanese lenders’ reluctance to dispose of bonds used as collateral also stokes a worry that the BoJ could soon face a bond shortage.
Spats reached a tipping point this year following the addition of negative rates to the BoJ’s ‘Quantitative and Qualitative Easing’. Two dissenting rate setters resigned shortly after. These exits and the safe-haven yen’s 16% ascent this year contributed to BoJ Governor Haruhiko Kuroda’s decision to announce a “comprehensive assessment” of policy over the summer.
Cue more stock market angst that left the Nikkei 225 down 14% since January.
As the dust settled in recent weeks, the likelihood that the Bank of Japan would throw in the QQE towel to any great degree has diminished.
BoJ decision: what to watch
- Official briefings and unsourced ‘guidance’ to the media have flagged a deeper rate cut into negative territory, though timing remains uncertain. The bank left wiggle room when it triggered minus ‘returns’ in January. The -0.1% rate applies to just 9%, or around 23 trillion yen, of deposits parked at the central bank. The BoJ could tweak its three-tier rate system, 0.1%, zero and -0.1%. A 20 basis point cut of the latter to minus 0.3% is likeliest.
- But we doubt it will happen tomorrow. In our view, recent economic data have been sufficiently ambiguous for the bank to keep forecasts largely intact. A probable Fed decision on Wednesday night to hold rates will also prey on Japan policymakers’ minds, as they weigh what could be one of their last chances to cut. A Fed ‘hold’ would soften the recently hesitant dollar even more. That will aid the yen, blunting the impact of a BoJ cut.
- BoJ yield curve tinkering seems likelier on Wednesday. Gov. Kuroda finally acknowledged this month that negative rates have hurt banks’ and insurers’ profits. As a sop, the BoJ could buy more short-term and fewer long-term bonds, which would help lift long-term borrowing rates. At ‘just’ 6 trillion a year currently, the bank has room to increase equity buying too.
- In a likely echo of its Washington neighbour, the BoJ has also floated lengthening the time frame before it hits 2% inflation, instead of its current goal of the year ending in March 2018. The BoJ will be more apprised than most institutions of government plans after Prime Minister Shinzo Abe’s latest extension of ‘Abenomics’ unleashed 7 trillion yen in fiscal spending, with more to come.
Fed almost balanced
By and large, Janet Yellen’s Fed is under less pressure to act than the BoJ.
But US rate-setters’ face a similar threat to their credibility as their Tokyo counterparts. Wednesday’s policy update is expected to be accompanied by the fourth cut in 15 months of the Fed’s long-run ‘neutral rate’. The bank’s forecasts have been eroded by stubbornly weak core inflation—as weak as 1.6% year-to-year in August using the bank’s preferred Personal Consumption Expenditures (PCE) price index, well below the bank’s long-standing 2% target.
The PCE result was backed by miniscule overall Consumer Price Index (CPI) growth released last Friday. The core annual CPI outcome was unchanged at just above the Fed’s target, providing the main source of debate among Federal Open Market Committee’s rate (FOMC) setters. But a raft of recent weaker-than-expected data from other parts of the economy kept Federal funds futures contained.
Implied probability of a hike at the time of writing was just 18% compared to 12% a day earlier, according to CME Group data. Probability of a rise at November’s Fed meeting was 23%, and in December 48% vs. 45%.
Bond traders are also sceptical. The yield spread between 10-year Treasury Inflation Protected Securities (TIPS) and benchmark 10-year Treasurys widened almost two basis points to 1.5% after Friday’s CPI release. But that still left this implied bond market forecast of inflation below the Fed’s target, after it fell below 2% two years ago.
Blasé expectations and a pause in growth have crushed the Fed’s earlier hope to hike four times this year. And then there were just two hikes projected. Now, with less than three months of 2016 left, only one seems plausible.
Fed decision: what to watch
- Conspicuous lack of recent guidance seals the probability of no federal funds target rate hike from 0.25%-0.50%. From our reckoning, the Fed has not delivered the kind of shock that a rate hike would bring whilst Fed funds futures and TIPS have been so low, since 1994.
- A ‘hold’ decision pushes the focus partly on to forecasts. Unofficial signals point to mere tweaks of economic figures, but median longer-run rate forecast could fall to 2.75%, down 1 percentage point from 18 months ago and 2.5 percentage points lower than in 2012.
- Changes to the Fed’s statement could hold clues.The July statement said risks to Fed forecasts had “diminished”. This could be changed to say risks are “balanced” or “nearly balanced”. A similar sequence of changes preceded the Fed’s first rate hike in almost a decade in December 2015. As many as 7 out of 12 rate setters have signalled a desire to hike this year, underlining thin FOMC consensus, and a more hawkish statement could be a sop to them.
The Bank of Japan decision is scheduled only tentatively and expected early-am London time. The Federal Reserve’s decision will be announced at 7pm BST.
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