Central bankers feed the greed

Mar 22, 2024

It’s all gone a bit Gordon Gekko.

Key points

  • The Fed left rates unchanged, but the commentary revealed the dovish preference of the FOMC.
  • It was a big week in Japan as the BoJ called an end to the era of Negative Interest Rates and Yield Curve Control.
  • New record highs in Japan stocks are highlighting a change in psychology and behaviour now underway in the country.
  • With central banks globally either cutting rates or tilting that way, the macro narrative is one in which policymakers are feeding the market's greed.

This week’s Fed meeting offered little new information to investors, with yields hardly changed. However, the fact that the FOMC revised estimates for growth and inflation slightly higher in 2024 – although continue to signal three rate cuts over the coming nine months – was seen as revealing a dovish preference on the part of Powell and colleagues.

In this sense, it might appear that the Fed would like to start lowering interest rates in June. The problem remains though that economic data are not showing many signs of slowing, and recent price data have disappointed on the upside. In that case, we continue to see rate cuts only coming in the second half of the year, with the Fed needing to remain patient in the interim.

Meanwhile, risk assets continue to push higher. The stock market continues to hit new records and credit spreads continue to narrow, helping to ease financial conditions, as well as driving positive wealth effects.

With Powell sounding like he wants to be the market's friend, it is understandable that investor psychology continues to move ever more assertively into ‘greed’ territory. Inasmuch as this can feed back into consumption and price setting behaviour, so this is a further factor as to why we think it will become necessary for the Fed to ultimately temper, rather than continue to fan, rate cutting expectations.

We continue to see Treasuries not far from fair value and don’t see a position as currently warranted. Although data may continue to push against lower rates, we think that market participants will accept the idea that rate cuts can be pushed back, just as long as they continue to maintain confidence that a substantive easing cycle will follow. This latter facet is something we remain more inclined to question.

Certainly we think that it remains incongruous to simultaneously look for the Fed to cut rates by >200bps at the same time as believing in a soft landing for the economy. The only way this seems plausible would be if inflation proves surprisingly benign, yet with the labour market tight and service price inflation appearing sticky, we think that this outcome remains unlikely.

Meanwhile, the past week was a more momentous one in Japan, with the BoJ calling an end to the era of Negative Interest Rates (NIRP) and Yield Curve Control. These moves were in line with our thinking and the fact that this outcome occurred earlier than many domestic investors had previously been expecting. This once again highlights how the speed of change in Japan is starting to gather pace. Inflation remains well above the 2% target and in the wake of the 5.3% Shunto wage round, we continue to project price risks to the upside. This is also exacerbated by a weak yen.

The Japanese currency weakened after the BoJ decision, as investors concluded that notwithstanding the symbolic significance of these policy acts, it does little to eat into the negative carry disadvantage suffered by yen holders at the current point in time. Furthermore, the fact that the BoJ continues to grow its balance sheet through JGB purchases was also seen as underlying the BoJ’s commitment to policy accommodation.

It strikes us that the BoJ will need to take further steps at, or before, its April MPC meeting, if the yen is not to come under further pressure in the weeks ahead. Further yen weakness is seen as undesirable and will further raise upside inflation risks. This should start by an articulation that this week’s policy shift marks the beginning of policy normalisation, not the end of it. Forward guidance may be deployed similarly to the Fed, with the notion of a longer-term R* target, for where rates should rise to in an environment where inflation is stable at 2% and policy is at neutral.

Our discussions with Japanese policymakers lead us to believe that cash rates will be raised to 0.25% in July and then 0.50% later this year, as inflation remains robust. We also see the BoJ ending balance sheet expansion once rates hit 0.25%, though steps to shrink the balance sheet seem much less likely. The question for markets will be whether this is enough. It strikes us that upside risks in Japan are building, and Ueda and colleagues need to be attentive to data, lest they fall behind the curve and make a policy error.

New record highs in Japan stocks are highlighting a change in psychology and behaviour now underway in the country. We remain confident that this will ultimately mean that yen rates move higher, Japanese stocks rally and the yen appreciates in a broad-based Japan reflation trade.

However, for now, maintaining positions short in Japan rates continue to offer the best risk/reward in our eyes. We can see that the yen is undervalued, but undervaluation can persist. In many respects, so extreme is the undervaluation of the yen that this becomes a factor pushing Japan prices higher in itself.

Certainly, foreign tourists are spending very freely in Japan, and this is pushing prices higher in those stores and services frequented by visitors. This is also seen as having spillover effects. Yet for the yen to catch a bid, it seems that markets will need a clear line of sight in terms of how the policy gap on rates will narrow. From this point of view, any yen weakness at this point is very much down to the policies of monetary accommodation still being pursued by the BoJ.

The BoE meeting continued to emphasise the need to wait and see before taking any policy action. This week’s CPI report was a touch softer, though RPI was slightly above consensus. Some wage surveys have also suggested some wage moderation.

However, with the UK minimum living wage set to rise by 9.8% on 1 April, we continue to see wage pressures remaining elevated for some time. In the spring, headline CPI is likely to drop to 2% on base effects. However, we would highlight that core inflation will remain materially more elevated and service price inflation continues to track around 6%.

These are levels which are much too high for the central bank’s comfort. Consequently, we continue to struggle to see the BoE cutting rates soon and believe that UK rate investors are discounting too much good news at the current time.

That said, it is also notable to see Bailey and colleagues coming under increasing political pressure to ease from Tory party MPs. The Conservatives are desperate for a better economy to help lift their prospects and as base effects pull headline CPI lower, it is understandable that these calls could continue to grow louder over the next several months.

European markets have been relatively quiet over the past week. A decision to cut rates by the Swiss National Bank was largely expected, but helped yields across the continent on the narrative that it won’t be too long before the ECB follows in its wake.

Meanwhile, in sovereign credit, it is starting to feel like the recent rally in spreads is starting to lose some momentum. Moody’s raised its outlook on Spain to positive, though we feel that sovereign agencies continue to lag the market in discounting fundamental improvements which have been taking place.

Elsewhere, corporate spreads continue to trade firmly. The semi-annual roll of CDS indices did not trigger any notable market shifts and although spreads are now beginning to look slightly tight, we suspect that technicals can continue to drive a rally before spreads reach outright expensive levels.

Demand continues to outweigh supply at a time when net issuance is contracting slightly, even as allocations to fixed income have picked up after cash rates peak. For the time being, it is not clear what will change this dynamic, but it continues to be important to retain discipline and not be sucked into a rally, adding the wrong assets at the wrong price level.

In FX, much focus fell on the yen. The Japanese holiday coming the day after the BoJ rate decision offered a green light to those wanting to sell that currency on a view that imminent intervention is unlikely. Moreover, there is a sense that the best the MoF can do will be to smooth moves, rather than change the directional trend.

Elsewhere the US dollar has been recouping some lost ground versus the euro. With the ECB more widely seen to be cutting rates ahead of the Fed, we are inclined to look for the euro to trend towards USD1.05, even though we regard the dollar as materially overvalued on a PPP basis.

Looking ahead

We think that this week will be remembered as the first step in a process of policy normalisation in Japan. Given our view on the data, we are confident that further steps will be forthcoming and in light of that, the more that the yen is under pressure in the short term, so the more likely it is that these steps will come more quickly into view.

This calls for patience in terms of short positions in Japan rates in our opinion. With respect to the yen, here we must be more disciplined with respect to the timing of a potential long yen trade, given the penal cost of carry which investors face.

Otherwise, with a number of EM central banks cutting rates, the Swiss also easing and the Fed, ECB and BoE all tilting towards lower rates, the macro narrative is one in which policymakers are feeding the market's greed. This is leading risk assets to deliver some bumper returns as recession fears melt away and as bears are forced into hibernation.

However, history tells us that markets can often be most vulnerable when risk attitudes become complacent. There was a line in the movie 'Wall Street' that 'greed is good'. However, greed has consequences and it rarely ends well. It will pay to be disciplined and stay vigilant.

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