There’s been no shortage of speculation about whether the Fed “got what it wanted” out of Wednesday’s “dovish” rate hike.
In one camp are those who believe Yellen and co. are probably pleased with the outcome. The “Fed put” (and accompanying BTFD mentality) was reinforced by the dovish messaging and this was reflected in equities rallying into Wednesday’s close. Another camp thinks perhaps the committee didn’t intend to effectively turn a hike into a cut and will now be forced to talk up future hikes to avoid loosening financial conditions even further.
Whatever your interpretation, one thing is pretty goddamn clear: the buoyancy we continue to see in risk assets is predicated upon the perpetuation of the accommodative policies that have levitated asset prices for going on a decade.
There are very real questions about what happens when the $400 billion/quarter central bank liquidity flow ebbs. In short, this is what we’ve gotten used to:
What happens when the spigot isn’t wide open anymore is anyone’s guess, but for his part, Citi’s Matt King thinks maybe you should be concerned:
Regular readers will know that our favourite model for markets’ behaviour in recent years is their correlation with central bank liquidity. While the scale of their purchases over the past half-year or so has been close to record highs, it is already diminishing, and set to diminish further.
BoJ purchases have almost halved since their shift to yield targeting; ECB purchases will be reduced by one quarter from this month on. In EM, FX reserves have held up well since February last year, and in recent months have been propped up as EM portfolio inflows have gone a long way towards offsetting a worrying trend towards net FDI outflows. But this too we suspect was aided by the Fed being on hold, and is liable to face renewed pressure as it returns to rate hikes. Besides, the extent of the rally once again seems excessive even for today’s level of CB purchases, never mind relative to its likely future trajectory.
Throw in the fact that this week’s “stealth” tightening (the OMO hike) in China is further evidence that the driver of the global credit impulse is being gradually curtailed, and you have to wonder if we’re on the precipice of an epochal shift in the way we think about markets.
Given all of that, I thought the following summary from BofAML was useful in terms of giving readers a quick pocket guide to where central banks stand as we look forward to a rather uncertain future.
Central Banks: Silence Is Golden
Lessons learned. With the Fed signaling then hiking in the past week, there has been increasing talk that rate hikes may not be that far away in Europe and Japan. We disagree and more broadly believe central banks will remain very supportive of growth in the year ahead.
In our view, central bankers have learned three key lessons in recent years. First, don’t be “head faked” by higher headline inflation: the core is a much better gauge of future inflation. Other than hard-core hawks, we expect central bankers to look through the pick-up in headline inflation. Second, the neutral or equilibrium rate consistent with healthy growth is a lot lower than in the past. Third, patience is a virtue: in the past a number of central banks, including the ECB and BOJ, have declared victory prematurely. We expect both to stay the course much longer this time around.
This dovish tilt is confirmed in our forecasts for real and nominal policy rates (Table 1). Even with three Fed hikes this year, average policy rates for the countries we cover are expected to barely rise in nominal terms and dip when adjusted for headline inflation. Let’s take a closer look at the big four central banks.
Fed: back to baseline. Clearly the Fed has adopted a more hawkish tone. However, it is important to not over interpret the Fed’s “pre-announcement” of its March rate hike. In our view, the core of the Committee is finally, belatedly, acknowledging that the economy is at full employment and wage and core price inflation are slowing accelerating. They are shifting focus from downside risks to the benign baseline for growth and inflation. Why did they “pre-announce” in such a clear fashion? In our view, this was an attempt to take all the shock out of the move. In a politically charged environment, the Fed would rather have the news headline be: “As expected, Fed hikes rates,” rather than “Fed surprises markets and analysts, hiking despite low inflation.” Despite the slow start to the Fed’s tightening cycle we do not think they are “behind the curve” in any meaningful sense and hence there will be no “catching up.” Yes, they are hiking much slower than normal and they are risking overshooting their inflation target. However, as we have noted before, overshooting the target when the economy is in the late “hot” stage of the business cycle is the only way to achieve the target on average. Indeed, at least four members of the Committee now forecast that core inflation will rise above the target by 2019. Thus the Fed will likely continue to move carefully even as core inflation moves above 2%.
ECB: first things first. The markets are now pricing in some chance of an ECB rate hike before year-end and there is speculation about whether they could start hiking before they taper their bond purchases. We think such a move is quite unlikely. While politics are beginning to constrain the bond buying program, rate hikes are likely only when there is significant progress in raising core inflation and only if the ECB feels comfortable about the impact on the Euro.
BOJ: a winning formula. Another central bank that seems to be learning from its mistakes is the Bank of Japan. The shift to yield curve control has worked nicely for Japan. It prevents fiscal easing from boosting borrowing costs and crowding out private investment. It also means the global bond market sell-off helps Japan—by weakening the Yen—rather than hurting Japan by raising borrowing costs. Moreover, the BOJ has committed to continue expanding its balance sheet until inflation exceeds 2% on a sustainable basis. Izumi Devalier notes that this “overshooting commitment” doesn’t apply to its rates targets. But it does suggest that central bank is in no hurry to tighten policy and makes a premature rate hike very unlikely.
China: tapping the brakes. The PBoC has been moving to a slightly less accommodative stance, nudging up the 7- day repo rate from 2.7% in January to 2.9% in February and working with other regulators to slow off-balance-sheet financing. However, credit expansion has not slowed and we expect further attempts to constrain credit. Nonetheless, with consumer price inflation running at about 2% real borrowing costs remain low. At the same time, the move away from a semi-peg to the dollar has allowed a significant weakening of the Renminbi in the past two years. As a result, the BofAML FX Compass model now suggests the Renminbi is right at fair value.
Regime risks. Of course, this relatively benign environment is not without risks. One source of uncertainty is changing leadership at the major central banks. In Japan, Governor Kuroda and his deputies’ five-year terms end next March and April. In the US, Chair Yellen and Vice Chair Fischer’s four-year terms end next February and June, respectively. Indeed, by next July at least five of the seven seats in the Fed’s Board of Governors will have been vacated. However, in Europe, Draghi’s eight-year term does not end until October 2019.