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MV Weekly Market Flash: What We Learned from Policy Week

September 23, 2016

By Masood Vojdani & Katrina Lamb, CFA

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The tumult and the shouting dies, the Captains and the Kings depart. Rudyard Kipling’s 1897 “Recessional” comes to mind as we contemplate the remarkably quiet aftermath to September’s much-hyped marquee policy events. Yes, there was a frisson of excitement in equity markets after the Fed lived up to its reputation as the definitive cautious, controversy-avoiding institution of our time. And the yen went hither and yon in the immediate aftermath of the latest blast of new policies from the Bank of Japan.

But as the brief tumult subsides, the S&P 500 is back in its July-August corridor while the VIX has crawled into yet another low-teens slumber. The yen, meanwhile, has blithely brushed aside any notion of bite in the BoJ’s bark and is resuming its winning ways to the consternation of the nation’s policymakers. September is not yet over. With just one week left, though, this oftentimes fearsome month appears poised to go quietly into the night. So is it smooth sailing from now to New Year’s Eve? Is the overhang of policy risk off the table?

Dissent and Stern Words

We start with the Fed, where the policy debate was a simple will-they-or-won’t-they (we thought the matter was settled some time ago for reasons articulated in previous weeks’ commentaries, but still). Chair Yellen pronounced herself happy with the economy and the karmic “balance” of near-term economic risks, and put out a placeholder for December. A pair of hawks (Kansas City’s George and Cleveland’s Mester) were joined by habitual dove Rosengren of Boston in arguing for moving now.

That higher than usual dissent, along with a reasonable likelihood that headline economic numbers won’t deliver much in the way of surprises in the coming months, does raise the likelihood of a December move. In the absence of some global shock manifesting itself between now and the December FOMC meeting, in fact, a 25 basis point move would be our default assumption for the outcome of that meeting.

Unlike last December, though, when a quarter-point move led the way into a sharp risk-off environment in January, we think the Fed could get away with a move without roiling markets. The difference between this year and last? Those silly, yet telling, dot-plots showing where FOMC members see rates one, two and more years down the road. Last year, the consensus view was a Fed funds rate of 3.4 percent by the end of 2018. Reality took a bite out of that, though, down to what is now a 1.9 percent end-2018 view. In fact, apart from two outliers (anyone out there from KC or Cleveland? anyone?), nobody sees rates going above 3 percent for as far ahead as the eye can see. A benign, historically low cost of capital world appears to be our collective future.

The Drunk Archer

If there is a fly in the balm, though, the identity of that fly may well be the other party heard from in Policy Week. The Bank of Japan gave no clear indication going into deliberations as to what it intended to do. On the other side, it left no clear consensus as to what its flurry of policy measures actually meant: was it stimulative, or neutral, or maybe even restrictive in its practical implications? At least one clear winner emerged: Japanese financial institutions. By not further lowering already-negative interest rates, and adding a twist to the current QQE program likely to favor a steepening of the yield curve, the BoJ is sending a little love to its beleaguered member banks. The Topix Bank index jumped about seven percent in the aftermath of the announcement.

The problem with anything the Bank of Japan says, though, is that it has a credibility problem. That problem was very much on display with the other main platform of the Wednesday policy announcement, namely the stated intention to overshoot the longstanding two percent inflation target. The Bank hopes that by explicitly targeting an inflation rate higher than two percent (how high? not clear) it will finally be able to deliver on that monetary policy “arrow” in the original Abenomics blueprint: pull the economy out of its chronic flirtation with deflation.

The problem is that inflation in Japan has been nowhere near two percent for a very, very long time. The idea that a new mindset of inflationary expectations could suddenly take hold to reverse this longstanding trend is extremely hard to take seriously. To use the “arrow” metaphor of Abenomics, it’s as if a stone-cold drunk archer, wildly shooting at and missing a bulls-eye target, decides that the best way to hit the target is to move it even further away! It will take more than words to convince markets of any real change to Japan’s price environment – as evidenced by the yen’s prompt return to strength in the second half of this week.

Credibility Risk

Hence that “fly in the balm” comment we made a couple paragraphs above. The main risk we see in asset markets today is the credibility risk of the central banks that collectively have been holding things more or less together since the Great Recession. Lose that credibility and you lose a lot. Japan’s economy has been stagnant for 26 years, and policymakers there are still throwing pasta at the wall to see what sticks. In the absence of either normal levels of organic economic growth or intelligent economic policymaking by national governments, a loss of confidence in the ability of central banks to deliver effective monetary policy is not something we can afford to indulge. This is not a risk we see as likely to actualize in the very near-term, but it is a key concern looking ahead to next year and beyond.

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MV Weekly Market Flash: The BoJ’s “Bazooka” Backfires

April 29, 2016

By Masood Vojdani & Katrina Lamb, CFA

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The language with which the financial press documents the doings of central banks has taken a notable turn towards military vernacular in recent years. We have “shock and awe” campaigns to talk up growth prospects, and jaw-clenched proclamations of doing “whatever it takes” to stave off collapses in currency, bond or equity markets. Once more unto the breach, dear friends, once more! Descriptions of their policy implementation vehicles are likewise bellicose. Consider the “bazooka” by which Bank of Japan Governor Haruhiko Kuroda fired a new package of stimulus via quantitative easing and negative interest rates back at the end of January. Like most such stimulus programs, the explicit goal was to provide a monetary boost to stimulate economic activity, while the largely unspoken but implicit aim was to weaken the currency (the Japanese yen) and stimulate domestic asset prices. How’s that working out for the BoJ so far? Not so well, as the chart below shows. Since the 1/29 stimulus, the yen has soared against the dollar and the Nikkei 225 stock index has fallen even while world equity markets have enjoyed a broad-based rally.

Hold Your Fire

“Damned if we do, damned if we don’t” must be the frustrated sentiment in Nihonbashi, the Tokyo district where both the BoJ and the Tokyo Stock Exchange are located. Following another policy meeting this week, the central bank announced on Thursday that it would be holding off for the moment on any new stimulus measures. The no-action decision took markets by surprise, as most observers predicted the bank would serve up another cocktail of negative rates and/or increased asset purchases. Once again the yen jumped – this time by four percent in a single day – and stocks cratered.

The official reason for the decision to hold fire, according to Governor Kuroda, was that the bank is still assessing the impact of the January move. It would not be prudent, according to this argument, to implement new policies until members have a better sense of how the current ones are working. He added that the policy impact should be better understood in the not too distant future, giving a guideline of six months or so from implementation as a reasonable time frame. That sets up the possibility for another stimulus move in June, which of course would pull it firmly into the gravitational tractor beam of Janet Yellen and her FOMC colleagues. The Fed meets on June 14-15, and pundits are currently split as to whether rates are likely to rise or remain on hold following that meeting. Should the Fed raise rates in June, Kuroda’s thinking may go, it could give some added force to another round of BoJ stimulus for the Japanese economy. And such a move would be very much in keeping with the Japanese governor’s established penchant for big, dramatic moves rather than incremental policy tweaks.

Running Out of Ammunition?

Such a move would also support an increasingly prevalent view that while the BoJ’s bazooka may be in fine shape, it is running low on ammunition. The decision to move into negative rate territory was controversial when it was announced and continues to be a matter of contention in Japanese financial circles. There are limits to how far into negative territory rates can go, even if no one really knows where that lower bound is. On the quantitative easing side, any moves by the BoJ into riskier asset territory like common stocks are also likely to generate resistance.

Meanwhile, the economy shows few signs of improvement. At this week’s post-meeting press conference the BoJ announced a series of downward revisions to its economic forecasts. Growth is now projected to be 1.2 percent versus the prior estimate of 1.5 percent through March 2017. Inflation – which Governor Kuroda has pledged to see reach the target rate of 2 percent before he leaves office in 2018 – was also revised down from 0.8 percent to 0.5 percent. The likelihood of a return to 2 percent within the next 24 months is looking ever less likely. Labor market conditions have improved but, as in other countries, a fast clip of jobs creation is failing to deliver the kind of wage increases normally seen in the past.

Given this context, it perhaps makes sense that the BoJ would keep its limited store of powder dry for now and hope to get more bang for the buck (ahem, yen) in a June move. But it is a risky gambit; the Fed is far from certain to raise rates then, and any number of other unknowns could manifest between now and then to complicate the policy landscape. Governor Kuroda has two years left in his term to shore up the BoJ’s credibility. Increasingly, that credibility appears to be dependent on events beyond his control.

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