Article / 19 September 2016 at 13:52 GMT

A critical week for markets

Head of FX Strategy / Saxo Bank
Denmark
  • FOMC, BoJ meetings in focus as QE hits the wall
  • Global bond and currency markets shaky, volatile
  • Greenback, yen could move wildly on decisions

Excess liquidity
Taking on water: Endless easing has flooded markets with excessive liquidity, and the result is a breakdown of traditional correlations and the total distortion of bond markets. Photo: iStock

By John J Hardy

The Bank of Japan and US Federal Open Market Committee are both announcing their latest respective policy decisions this Wednesday. Markets have been volatile recently as the major central banks are giving off signals that they are growing disenchanted with their ability to do more with the tools at hand – namely, quantitative easing and zero-to-negative rate policies. 

At its September 8 meeting, the European Central Bank was "loudly silent" on its intention to do anything beyond its current QE programme, leaving some to suspect that the bank will begin tapering asset purchases starting sometime early next year as it runs up against difficulties in finding sufficient sovereign bonds to buy.

Elsewhere, BoJ sources have indicated a very divided monetary policy board as the massive size of the central bank’s purchases have resulted in a dysfunctional market that has almost ceased functioning. Some on the board favour a retreat from the current programme, while others, including governor Haruhiko Kuroda himself, are willing to forge ahead with rate cuts even deeper into negative territory. 

But even those favouring more activism on negative rates, are concerned that the BoJ’s QE programme has crushed long Japanese bond yields to unhealthily low levels as zero rates across the curve impacts the profitability of Japanese banks (who can’t extract reasonable profits from the traditional borrow-short, lend-long strategy when long yields are near or even below zero). 

QE that crimps banks' willingness to lend is self-defeating. So even if the Bank of Japan announces a rate cut this week deeper into negative territory, it could simultaneously indicate a shift in its purchase pattern that could have dire consequences for global bond markets. 

Already, global bond markets have been destabilised recently by this news, and the spike in volatility – further aggravated by the ECB’s climb-down from further policy guidance and hawkish noises from the Fed – has spilled over into risk assets and currency markets in general as well. 

The riskiest emerging market currencies, for example, on a massive rally since trading at end-of-the world prices during the market meltdown that started 2016, have suffered a sharp correction.

In short, markets are holding their collective breath this week in anticipation of the latest guidance. The key for traders this week, however, is to maintain the longer-term perspective amidst the short-term noise. 

In the grander scheme of things, central bankers are losing their ability and desire to do more of the same as the ECB and BoJ are bumping up against practical limits to further intervention and loudly highlighting the need for a fiscal focus if policy is to move the needle. Meanwhile, the Fed is slowly beginning to throw off signals that it is not confident in its own policy options, with an increasing number of Fed members pointing to fiscal stimulus as the next policy choice if the economy weakens again. 

Could the Fed on some level be aware that excessive central bank pumping of asset markets has been the chief contributor to the rise in inequality? And could the Fed ever recognize its responsibility for directly feeding the rise and possible election of Donald Trump as the next US president?

Donald Trump
Fedkenstein's monster? Photo: iStock
Regardless of whether the BoJ and the FOMC surprise on one side or the other this week, remember to see the forest for the trees. The last few years have shown us that central banks never had any mojo to move the real economy at the zero interest rate bound, and are in the long and fraught process of recognizing the impotency of their excessive liquidity provision. 

Meanwhile, the will do everything possible to step back from their prior course without upsetting the monster of their own creation: liquidity-stoked bond and stock markets. 

(But that won’t be possible beyond the shortest term.) 

As for currencies, if bonds and equities both come under pressure again, the USD is likely to rise sharply as a safe haven while the yen could gyrate wildly, first stronger as the market sees the beginning of the end of the BoJ status quo but then perhaps sharply weaker again when the market considers the implications of higher yields for a country buried under a mountain of debt. 

Fasten your safety belts.

— Edited by Michael McKenna

John J Hardy is head of FX strategy at Saxo Bank

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