Given the current stance, the proverbial central bank put is out-of-the-money for now. In other words, central banks are unlikely to be deterred by the first e.g. 10% decline in equity prices, and are likely to be encouraged in tightening policy if risky assets remain resilient.
That’s from Deutsche Bank (out late last week) and it underscores the same point that pretty much everyone on the sell side is making. Namely that at this point, central banks are concerned first and foremost with a “shadow” mandate that centers around leaning against easy financial conditions – inflation be damned (for now, anyway).
Bubbles in risk assets and excessive risk taking have become impossible to ignore. Between clearly overvalued stocks, the bulletproof character of EM, the ‘carry’ on mentality supported by the low vol. regime, and a generalized sense that market participants are asleep at the wheel, policy makers appear to have finally seen enough.
And that’s bad news for all the people who have gotten used to calling central bankers’ bluffs. Earlier today, we brought you the latest from Deutsche Bank’s Mikihiro Matsuoka, who lays out a compelling case for the notion that the removal of accommodation poses a far greater risk to market psychology than any idiosyncratic trigger event that’s tipped the first domino in previous crises.
Underscoring that notion is a new piece out from BofAML, who discusses what Friday’s jobs data means in the context of hawkish central bank rhetoric before saying precisely the same thing as Deutsche: you can count on the central bank put, but not until you lose 10%.
We see a number of market inconsistencies that are not sustainable in our view. Strong equities performance, EM asset appreciation, and low implied volatilities point to a strong global economy and a risk-on market. However, low yields, high cash balances and the strong JPY point to high risk aversion. Both sides cannot be right.
Moreover, these inconsistencies have survived the recent hawkish turn by a number of central banks, including the Fed. The market expects good data, low inflation, and loose monetary policies. The consensus seems to be that more central bank tightening will be a policy mistake, the realization of which will keep central banks from doing it.
In this context, Friday’s labor market data in the US could not have been more balanced, keeping everyone happy. The Fed can argue that the earlier weakness in the data was indeed temporary and the NFP print justifies tightening. Bullish investors can argue that slow wage earnings do not justify any rush to tighten. The data has not delivered the verdict we were hoping for on whether the Fed or the market is right. The market will continue fighting the Fed for now.
Still, we believe that the Fed will win. The latest FOMC minutes suggest that the Fed is focusing on financial conditions, which have been loosening as the Fed has been tightening, and is also concerned about unemployment being below its natural rate. Having monetary policy too much behind the curve could eventually lead to overheating and asset price bubbles, with an adjustment that could bring deflation risks back. Better take advantage of the good times to normalize policies than wait for too long. The recovery is advanced and does not justify crisis-driven policies. By any measure, global monetary policies remain very loose anyway.
In our view, the market is right to count on the central bank put, but we expect it to be relevant only after a sharp market correction. It seems to us that central banks want to become more independent from markets and avoid to be seen supporting them from already high levels. We believe that central banks would be willing to let the markets correct lower and would act only to avoid a panic that could affect the recovery and the inflation outlook.
Other central banks have more breathing space as the Fed is leading the hawkish turn and can sound more balanced without being concerned that their currencies could overshooting. The ECB is trying to justify QE tapering at a time when inflation remains well below its target by arguing that the policy has already addressed deflation risks and is not needed anymore, although we would expect it to keep interest rates low for as long as inflation is low. The BoE is a surprise for markets, turning hawkish as the data is turning weaker and the difficult Brexit negotiations have just begun, but we had warned about such a risk.
The BoJ is the only exception, but markets do not seem impressed. Last week, the BoJ appeared ready once more to defend its 10y yield target. We trust that the BoJ will stick to its framework, eventually supporting USDJPY as the markets priced more Fed hikes. However, in the short term we are also concerned about a risk-off market correction that could be negative for USDJPY.