Last week was probably the most important week of the year in terms of macroeconomic news. The Bank of Japan (BoJ) was underwhelming in most respects, but creative in others. The BoJ kept the deposit rate unchanged at -0.1% and its annual Japan government bond (JGB) purchases at ¥80trn. Additionally, the BoJ scrapped the 7-12 year average maturity target for bond buying and replaced it with a yield target on 10-year JGBs around the current level of 0%.
After the BoJ meeting, and the European Central Bank (ECB) meeting earlier this month, the question remains whether these two banks are inching towards a regime change. This shift won’t be a Federal Reserve (Fed) style tapering announcement, because the motivation would be operational and political constraints rather than attainment of macroeconomic goals. A series of minor pivots, over a succession of policy meetings through 2017, can focus minds on the endgame in overvalued bond markets. Thus leading to position adjustments (accounts remain long duration), higher yields, capital repatriation and currency strength.
It is pretty clear that both the BoJ and the ECB have moved away from specifically targeting currency weakness and are open to allowing their currency to appreciate. Devaluing the currency doesn’t work when everyone is doing it, even the Swiss National Bank (SNB) was forced to accept a stronger Swiss Franc and abandon the floor of 1.2 against the Euro. This regime change may not be as clear in real time, compared to the Fed signals in 2013, but there seems to be enough circumstantial evidence that something is changing. We remain comfortable with forecasts for a higher yen and euro over the next year.
So if the ECB and the BoJ are not driving the Euro and the Yen lower, can we see a U.S. Dollar strength caused by the Fed? We believe this is very unlikely. The Fed delivered what some market participants are calling a “hawkish hold”. The statement offered a mixture of tones: they are on hold “for the time being” and the risks are now seen as “roughly balanced.” They “judged that the case for an immediate increase in the federal funds rate is stronger,” yet “it would be sensible” to wait. There were three dissenters, but they were all regional presidents, not board members, which is a key point.
The bottom line, at the beginning of the year, the Fed signaled four hikes by the end of 2016 and now the most they can do is one. The case for monetary policy divergence is less transparent. A December hike remains likely, but it is far from certain. The upcoming U.S. elections can easily cause volatility to pick up, and if we get a softer employment report in October or November, we might get another “hawkish hold” in December.
The U.S. Dollar is likely to remain the most fragile currency in 2016 (see Exhibit 1), the only exception being the British Pound, which is weakening due to Brexit.Download to read more