Strategy: BoJ’s new steps leave markets underwhelmed

26 Sep 2016

  • What to make of the Bank of Japan’s words
  • Can the BOJ actually take effective actions on inflation?
  • Fed decides on a ‘hawkish hold’, remains on course for a December hike
  • Asset allocation: taking profits on short GBP vs. USD

After the ECB earlier this month, last week it was time for the US Federal Reserve and the Bank of Japan to decide on the course of monetary policy. The Fed did not astonish the markets with its decision to keep rates on hold, but BoJ governor Kuroda had a surprise up his sleeve: he effectively moved the policy focus to yield-curve targeting, pinning the 10-year government bond yield at zero. On balance, we think the messages from the Fed, the ECB and the BoJ have even become more dovish. In itself, this should be positive for risky assets, but in our view, much of this had already been discounted.

WHAT TO MAKE OF THE BOJ’s POLICY CHANGES?

Measures to steepen the yield curve to mitigate the pain of negative rates for the banking sector and increasing the annual pace of asset purchases had been seen as policy options for the BoJ to fan inflation. In our team, we had discussed the possibility for the BoJ to scale back its bond buying. With bond availability tapering off, the central bank should be able to keep yields low with smaller purchases. Essentially, this is what governor Kuroda did. Also new was the BoJ’s commitment to overshoot its 2% inflation target, continuing its monetary expansion (quantitative easing) until inflation exceeds and stays above the target sustainably.

The new steps failed to impress the markets. We think there are several explanations. Market participants may have underestimated the importance of the new Quantitative and Qualitative Easing with Yield Curve Control framework. The commitment to overshooting its target may raise inflation expectations and thus lower real yields, supporting the economy and ultimately inflation. Perhaps markets focused on the unchanged JPY 80 trillion in annual asset purchases and the unchanged -0.1% official interest rate and failed to see any clear action to back up the promises on inflation and thus worried about the BoJ’s credibility.

Also, there are some questions. How aggressively would the bank defend yields against an upward drift? Pretty aggressively, we would assume. Monetary policy could thus become decisively pro-cyclical: tapering in a downturn when yields drift to below the target and stepping up the pace when the outlook for growth and inflation improves, causing yields to drift higher. In our view, it looks like the BoJ just hopes that inflation will drift higher amid the tighter labour market and the improvement in what the BoJ labels the backward-looking adaptive inflation expectations. Lower rates and yields targets may still come though.

Will this be a blueprint for other central banks? It could be in the US where the Fed also just has one government bond market to target. But the ECB would have to set target yields for different countries and should be ready to defend those targets. We believe the ECB should drop the capital key[1] in its asset purchases and be ready to buy ‘peripheral’ member states’ bonds to help quash any market speculation on higher bond yields. We think this is not feasible politically at this point.

A ‘HAWKISH HOLD’ BY THE FED?

The Fed holding monetary policy was no surprise, but the – unique – dissent by three members of the Federal Open Market Committee who favoured a rate increase now was. Interestingly, Boston Fed president Rosengren, normally a more moderate to dovish policymaker, was one of them. With Fed chair Yellen reiterating that the case for a rate hike had strengthened, the markets were left with the impression that the pause in the tightening cycle would end soon.

The perception of a ‘hawkish hold’ was offset by dovish points. An overwhelming majority of FOMC members now favours of just one rate increase this year, while the median of the policymakers’ views on rates in 2017 and 2018 has fallen. The median longer-run fed funds rate is still forecast at 3%, but the distribution around that mean has shifted down markedly.

This has not changed our outlook for monetary policy in the US. We still expect the Fed to hike in December. In its comments, the Fed may from time to time sound more hawkish to prevent the market-implied probability of a December rate rise, currently at 55%, from drifting to below 50%. The gap between the market view that the Fed will raise rates only gradually in coming years and the Fed’s own more aggressive forecasts looks set to close in favour of the markets.

ASSET ALLOCATION: TAKING PROFITS ON SHORT GBP VS. USD

Market volatility has stayed low after the latest round of central bank policy meetings. Obviously, volatility in the Japanese government bond market has now become virtually irrelevant. But the prospect of a continued easy monetary policy in the US, the eurozone and Japan has capped volatility in other markets too.

That said, the theme of steeper yield curves looks short-lived at this point. This should benefit risky assets generally, except for the financial sector. In fact, this sector dragged down European indices early this week, although this was also due to issues in Germany and Italy. A drop in oil prices as investors doubted that there would be any effective results at this week’s oil producers meeting did not help sentiment. This fits with our underweight in commodities.

We remain underweight emerging market debt in hard currency versus US Treasuries and global equities. We have hedged the upside potential in risky assets through an overweight in US small caps versus large caps and have added out-of-the-money December call options on the US S&P500 equity index. These were looking attractively valued.

With the pound down by more than 10% since the Brexit vote, we decided to take profits on our underweight versus the US dollar, even though we may not have seen the full impact of Brexit on the UK economy and the currency yet.

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[1] The capital of the ECB comes from the national central banks. Their contributions are calculated using a key which reflects the respective country’s share in the total population and gross domestic product of the EU. More on https://www.ecb.europa.eu/ecb/orga/capital/html/index.en.html

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