September Rates Update

Monthly Commentary

October 03, 2016

The month of September was dominated by central bank meetings as the Federal Reserve, Bank of Japan, European Central Bank and the Bank of England all held policy meetings. Notably, the sentiment around this month’s meetings was a bit different than in past years as the market has started to question the efficacy of further central bank easing. Judging by Treasury market price action, the summation of global central bank action for September left something to be desired by the market as Treasury yields finished lower on the month led by the 5y point. If the market starts to lose faith in the ability of central banks to generate growth and inflation, all eyes will continue to look toward fiscal policy which has been nonexistent globally in the aftermath of 2008-2009.

The ECB kicked off a very full September Central Bank policy meeting card by surprising the market to the hawkish side when they failed to announce any extension of their QE program, which had been expected. Remarkably, despite trimming both staff growth and inflation forecasts, President Draghi did not indicate that the ECB would look to augment policy any further in the coming months. While he did not guide the market toward further policy easing, it would be difficult to imagine that the ECB won’t take further policy action in some form in the future. As an inflation targeting central bank, it would be difficult for the ECB to remain credible without further policy tweaks given it has been 11 quarters since the staff revised their inflation forecasts higher. The market also appears to doubt that the ECB will be able to leave policy unchanged or taper in any meaningful way in the near future as the euro finished slightly weaker against the dollar for the month.

While their European counterparts felt that the best action was no action this month, the Bank of Japan rolled out a new policy framework referred to as “QQE with yield curve control,” at the conclusion of their September policy meeting. Under the new framework, the BOJ is abandoning the average maturity target of its Japanese government bonds (JGBs) purchase programme, which was 7-12yrs before the announcement. Instead, the Bank says it will now purchase JGBs to keep 10y yields at around 0%, effectively shifting to a yield-target-type policy framework. The Bank still says it will purchase JGBs more or less in line with its current pace (¥80trn per year), but its focus will now shift to yield curve management from the pace of QE expansion. To achieve this, the BOJ introduced two new operations, they will purchase bonds of a shorter maturity than in previous buying operations and they also will ramp up issuance of longer dated bonds in hopes of providing enough supply for Japanese financial institutions. In terms of forward guidance, the BoJ reaffirmed that they will continue expanding the monetary base until CPI exceeds 2% and stays above this target in a stable manner. In his post-statement press conference Governor Kuroda characterized the central bank’s new commitment to overshooting inflation as a “very strong commitment.” The bank also amended its ETF purchase program but kept the pace of purchases unchanged (¥6trn per year). It plans to purchase ¥2.7trn of TOPIX-linked ETFs, out of a total ETF purchase programme of ¥6trn. This tweak to increase investment in TOPIX-linked ETFs can be viewed as positive for banks, as most Japanese financial institutions are traded on the Topix exchange and not the Nikkei.

This move away from outright bond buying towards yield targeting is a welcome step for Japanese investors who have had to pay a premium for domestic FI instruments as a result of the BOJ’s bond buying program. By implementing a yield target on 10y JGB bonds, the BOJ hopes it will be able to steepen the JGB yield curve providing much needed relief to yield seekers. However, the BOJ is most likely not finished implementing its new policy as it appears the central bank will cut its policy rate deeper into negative territory in order to complete the steepening of their sovereign yield curve. Governor Kuroda seemed to allude to this in his press conference, saying “I still believe that the QQE with negative interest rate is very powerful because the most effective way of implementing monetary stimulus is to lower the real interest rate. On the other hand, the negative impact of the QQE with negative interest rate is true. We reinforced the previous one by adding the control of the yield curve.” It remains to be seen if this new policy will succeed but if the BOJ does indeed manage to meaningfully steepen the sovereign yield curve it could represent progress in their battle against deflation.

As the BOJ and ECB weighed policy easing options, the FOMC kept rates unchanged yet again at the conclusion on their September meeting despite the statement showing three dissents from Boston Fed President Rosengren, Kansas City Fed President George, and Cleveland Fed President Mester. Each of those FOMC members would have preferred to tighten policy to 50bp-75bps instead of deferring a potential tightening to later this year. The statement noted risks to the outlook were “roughly balanced” and that the case for a hike has strengthened, but that the Committee decided “for the time being, to wait for further evidence of continued progress toward its objective.” Having struck a similar tone last September as they walked the market toward an eventual December tightening, it seems that committee members are ready to begin inching toward another hike this December. However, with a growth rate of barely 1% for the 1st half of 2016 and estimates for strong third quarter GDP already starting to wobble, it remains to be seen if the FOMC will have scope to tighten policy in December despite desperately wanting to do so.

The release of the statement showed a Fed that hopes a tightening could be warranted in December, it was apparent from the release of the staff economic projections that hiking aspirations for 2017 and beyond are significantly more tepid than they have been. The staff’s forecasts for the Fed Funds rate now calls for one rate hike in 2016 (down from two before), two hikes in 2017 (down from three before), and three hikes in 2018 (same as before). Notably, the longer-run projection was snipped by 12.5 bps to 2.875%. The reduction to the longer-run projection in part reflects the fact that longer-run real GDP growth was also revised down to 1.8% from 2.0%. These downward revisions to both funds rate forecasts and growth suggest that the notion that monetary policy is less accommodative at current levels than previously thought is beginning to take hold inside the FOMC.

Despite kicking off her post-meeting press conference by characterizing herself as “generally pleased with how the economy is doing,” Chair Yellen did not seem eager to commit the path of policy in either direction at this point. In her view, “Since monetary policy is only modestly accommodative there is only little risk of falling behind the curve in the future and gradual increases in the federal funds rate will likely be sufficient to get to a neutral policy stance over the next few years.” However, she did indicate that she would be open to a tightening later this year insisting that the decision not to raise rates at the September meeting “does not reflect a lack of confidence in the economy.” The notion that the FOMC’s decision to defer any further tightening does not reflect a lack of confidence in the economy is a bit of an odd one, especially considering the FOMC staff projections show a 1.9% YoY growth figure over the next 3 years. Said differently, the FOMC currently does not believe the conditions are currently in place to tighten policy further, yet they forecast more of the same moving forward with the median FOMC participant expecting the policy rate to eventually reach 2.875% by the end of the hiking cycle. This notion that growth can remain low while the policy rate moves significantly higher may eventually prove to be unfounded but for now the FOMC seems content to apply their pre 2008 framework to 2016’s issues.

With only three months to go in 2016, it is somewhat concerning that despite another year of “easy” central bank policy globally, global inflation and growth metrics are near the same levels seen in 2015. This is not necessarily an indication that monetary policy has failed but it does raise questions about the impact of a central bank stepping away from adding further accommodation moving forward if economic data indicates that is necessary. It seems clear that the market is beginning to tire of failed forecasts and broken promises from monetary policy makers but absent economic improvement or large scale fiscal stimulus it would be hard to see any outcome other than the current status quo. Regardless of eventual outcome, September left the market with more questions than answers in terms of the path of near-term policy as well as the sustainability of global monetary policy in general.

Source: Bloomberg

Japanese 10y Sovereign Yields

Source: Bloomberg

Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents Under Their Individual Assessments of Projected Appropriate Monetary Policy, September 2016

Medians, Central Tendencies, and Ranges of Economic Projections, 2016–19 and Over the Longer Run

FOMC Participants’ Assessments of Appropriate Monetary Policy: Midpoint of Target Range or Target Level for the Federal Funds Rate

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