September 22, 2016
Operating at the Fringes - Limited Policy Options Remain
The central banks have spoken, and for all the expectations, no one really did anything. The BOJ and Fed were the latest and last of the largest central banks to do little during the beginning of the fall meeting season. To recap, the ECB was vaguely comfortable with its current program and stated that they did not discuss either extending its current program, which ends in March, or expanding the list of securities that it could purchase despite the general thought that it would run out of eligible bonds to buy by the end of the year. The BOE paused in providing further stimulus after the economy, and markets performed better than expected in the early stages of a post-Brexit world. In the first of this week's meetings, the BOJ also refrained from making any large moves, keeping its policy rate unchanged at -10 bps, while also keeping the size of their massive QE efforts unaltered. What it did do was announce that it would target trying to get the yield on the 10-year JGB to zero (which has averaged -7bps since August) while pledging to continue expanding the monetary base until inflation gets to at least 2%. These policy changes strike us as affirmation of the negative impact that the flattening of the curve has had on the banking sector. Additionally, the pause in QE and further rate cuts smell of policy limits with a depleting inventory of JGBs to purchase as well as the inability of negative yields to drive either growth or inflation. From this perspective, we view yesterday's BOJ actions are minor tweaks to its existing program that will do little to address the economic malaise that continues to confront the Japanese economy. The JGB market nonetheless did move in the desired direction, with yields rising up to 4bps across the JGB curve, although it is simply back to last week's levels. The shape of the curve was however mostly unchanged through the 10y and was actually flatter out to the 30 year maturity.
As for the Fed, it also did nothing, keeping rates unchanged as we and most investors expected. The policy statement and subsequent press conference stressed that the conditions were supportive of a rate hike, but the committee chose to wait on additional data before taking that step. The vote was far from unanimous, with three of the ten voters dissenting, the largest contingent in disagreement since 2014. The decision to not hike rates also required an update to the dots plot, which lowered rate hike expectations to one move this year, while also lowering next year's hike expectations to only two (from three), and an additional three in each 2018 and 2019. The terminal rate was also lowered to below 3% for the first time. The quarterly update to economic projections were tweaked to acknowledge the slower growth in 1H:16, while the unemployment rate was adjusted to account for a larger group of returning workers (UER raised by 10 bps to 4.8% in 2016), while headline PCE inflation was adjusted 10 bps lower to 1.3% in 2016. We found the introduction of 2019's GDP expectations at 1.8%, as well as the lowering of the longer term GDP estimate to that same level as telling of the new normal. In combination, the muddle through growth and inflation figures do not prompt a need to aggressively raise rates, which is likely a growing camp within the FOMC. Since we don't envision any major changes to economic data into the end of the year, a rate hike would likely be predicated mostly on the desire of the FOMC to replenish its fairly bare policy tool shelves. At the same time, there are plenty of possible volatility inducing events before year end such as US elections and referendum toned votes in Austria and Italy, to dash the Fed's hopes for a year-end hike. As such, we think that odds will eventually settle at 50/50 going into the elections, although we will maintain our December hike call, if for no other reason that the FOMC needs to save face after aggressively promoting its desire to raise rates before year end.
Markets were mostly muted after the BOJ as we awaited the decision from the Fed. The initial reaction has been a dovish interpretation of the Fed's actions, prompting a global risk rally. Treasury yields have fallen across the curve, with the long end outperforming as the curve has flattened 7 bps since Tuesday's close. European yields have moved in a similar fashion, albeit slightly more muted, with core and periphery curves also flattening. For the moment, Japanese yields are directionally following the cues from the BOJ, as yields are slightly higher, although there continues to be some flattening out to the long end. Stocks do not seem particularly concerned as to whether we have a hawkish hold in September or a dovish hike in December, as stock indices are higher almost across the globe. US stocks were 1% better yesterday, with most of those gains coming after the Yellen press conference. Europe is in a similarly ebullient mood, with the Dax up 1.7% this morning and Spain and Italy over 2% better during their morning sessions. The USD weakened yesterday, as we sense that traders are discounting the Fed's ability to eke out any rate hikes this year. DXY is 1% weaker, as the Euro and Yen are stronger by an almost equal amount. The strengthening Yen has pushed the currency back towards the 100 level, an unwelcome development for the BOJ which will undoubtedly stoke intervention chatter in the market. Yen strength may also be the catalyst that drives the BOJ further down the negative yield rabbit hole later this year, despite concerns over the efficacy of its policies. The weaker USD has also driven commodities higher, with oil 4% stronger in the past few days, while the broader commodity basket is 1.5% stronger.
Volatility has once again fallen after spiking since mid-August on concerns that the central banks were considering removing the liquidity punch bowl. Those concerns remain valid in our mind given the lack of any cognizant policy action during this cycle of central bank meetings. What has become evident is that there are fewer monetary tools available and going back to the existing policies is unlikely to generate the growth and inflation that was expected when these unconventional tools were unleashed. Having said that, there are few options, and the CBs will continue to press even if they only half-heartedly believe it will generate desired goals. From this perspective, investors will continue to push into risk assets, even though valuations are stretched in many if not most asset classes. Spikes in volatility are to be expected, although the CB put remains at the money. During the latest bout of volatility, high yield was one of the weakest performing asset classes. Its traditional correlation with stocks was evident, as the above chart shows a fairly strong correlation between HY spreads and the Vix. The overall credit environment nonetheless remains supportive, with issuance of both IG and HY remaining on pace to meet or exceed last year's record levels. While the default rate has risen to multi-year highs, with the rating agencies reporting a steady increase in the speculative grade default rate into the 5%-5.5% range, a multi-year high. These levels are also expected to increase another 100 bps over the next 3-6 months before topping out, as energy and material default continue to emerge. Despite these weakening default statistics, the overall rating environment has remained stable over the past few quarters, as stabilizing oil prices have not required additional downgrades after drastic cuts were made last year. Therefore the collapse in the Vix, if maintained, should translate into improving high yield spreads. There is limited data at this point in the month, and the next round of CB meetings will not occur until late October to early November. GDPNOW and NOWCAST have also recently converged towards the 2.9% range for 3Q:16 GDP, which is consistent with Fed commentary. Of course, October can never be discounted from a volatility perspective, as earnings are set to begin in just over two weeks' time. Not to be discounted is the final push in the US election process with the first debate next Monday, September 26th. While many of these events can cause volatility to flash, the trend in the market has been to mostly ignore them and rely on the CB put, which for the moment appears well entrenched in the market.
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