Fed and BoJ preview: Why September is turning into a dud
- ECB did nothing – bank will extend asset purchase program, but in December
- BoE did nothing –
it's watching Brexit talks and the economy
- BoJ isn't sure what to do –
there's no easy easing left
- US Fed will probably hold but signal a December hike
By Juhani Huopainen
The central bank meetings of September were supposed to be events of utmost importance. Then the European Central Bank (ECB) and the Bank of England (BoE) did nothing. It looks like this week both the Bank of Japan (BoJ) and the Federal Reserve will also refrain from further action.
The September dud is the closest reminder to political leaders that they will have to move ahead with coordinated fiscal programs and structural reforms. Given the political confusion and the approaching elections, it could be hard. But the only thing left in the central bank’s coffers is one lousy Christmas gift, and it will be all over after that.
The ECB is waiting – action in December
The need to announce policy changes was apparent before the summer holidays. The euro area was not getting closer to its inflation targets, and the European Central Bank’s asset purchase program (PSPP) was getting close to self-imposed limits. The consensus view is that under the current restrictions the ECB would run out of eligible bonds to buy before the year is over.
In order to continue the PSPP until its planned end in March 2017, changes to the program will have to be introduced. A majority of polled economists also believe the PSPP will be extended beyond March 2017, which makes lifting the restrictions even more critical.
Most investors expected clarification after the holidays. By waiting until the summer was over, it was rationalised that enough time would have passed from the Brexit referendum, and the new, updated central bank projections would shed more light on what needs to be done.
Nevertheless, the ECB stood pat in September. No rate cuts, no announcement on PSPP extension and no word on how the PSPP constraints would be dealt with.
The ECB impasse is a sign that even unconventional monetary policy is close to its limits. The next available options would be highly controversial, and their effectiveness questionable, especially if such measures were not supported by easier fiscal policy and burden-sharing by the euro area’s national leaders. When you are low on ammo, it is better to save the ammo for deterrence instead of taking a couple of crazy shots.
Secretly the ECB is hoping that a Fed hike and thus a stronger USD would do some of the lifting for the ECB as well. The consensus view is that the ECB will lift some of its self-imposed restrictions, maybe at its next meeting, or by the latest in December. The announcement to extend the asset purchase program by six months or so will likely be presented at the December meeting. But that will be the ECB’s last Christmas present.
The Bank of England is waiting – for Brexit
The UK government will likely make the official Article 50 request to exit the EU during the first quarter of 2017. This will launch a two-year period of negotiations between the UK and the EU. GBPUSD is still within the post-referendum narrow range, and it oscillates within that range on economic news (which had strengthened the GBP in early September) and hints on how tough the eventual negotiations will be (which has recently weakened the GBP).
Hourly GBPUSD chart shows a narrowing range:
...but the monthly GBPUSD shows "new post-1985 lows" is not completely unheard-of, and around current levels GBPUSD is historically cheap:
BoJ: Confused and close to the limits – will it wait too?
The BoJ is obviously nervous that its massive asset purchase programs have not created sustained JPY weakness. While officially Japan is not attempting currency devaluation, everyone knows that it was and is a major goal of the central bank in its attempt to increase its target inflation rate and jump-start growth.
The central bank was expected to act in July, lowering rates and increasing asset purchases, but instead, the BoJ only modestly increased the size of its asset purchases and promised a “comprehensive review” of its monetary policy.
The BoJ is close to the limits – it is already buying practically everything from bonds to stocks, and can’t conveniently find new asset classes to buy or increase the size of its asset purchases without becoming too large a market participant.
Mohammed El-Erian argues in his latest column that this problem is quite similar to the ECB’s problem – monetary policy’s limits are getting closer, and unless the government can increase fiscal spending and introduce structural reforms, getting even closer to those limits is really not worth the trouble.
The BoJ was the first large troubled central bank to lower interest rates to aggressively negative levels – and what followed was JPY strength. Just as BoJ taught the ECB about the perils of negative rates, it will again act as a laboratory where the broken link between the central bank and the government is about to be mended. The aftermath of whatever BoJ announces will be closely watched by the ECB.
This confusion over whether the Bank of Japan will announce massive easing, or again show only limited interest in monetary expansion, shows in the JPY technical charts.
Both the USDJPY and EURJPY have now reached a major support level. The weekly charts suggest both pairs could be turning higher:
The daily charts show no signs of bullish reversal, but instead bearish trend channels for both the pairs. The long summer and sideways trading have brought both pairs close to the upper line of the bearish channel, suggesting further downside could be next:
Fed: no hike now but a pledge to hike in December (bullish for USD?)
While the US Federal Reserve is often talked about as being the first central bank to begin hiking rates after the financial crisis, in fact it was the ECB, which hiked rates once in 2008 and then in 2011. The ECB’s 2008 hike was a “continuation hike”, the last hike after many previous ones, at a time when the Fed was already easing aggressively.
The ECB’s two hikes in 2011 were a failed attempt at achieving lift-off, which only led to the euro crisis getting critical during the following year. It feels to me like the Fed’s December 2015 rate hike was somewhat similar to the ECB’s disastrous attempts to hike rates.
The ECB had to quickly reverse its hikes, while the Fed has been forced to reschedule its hikes from the old normal of four hikes to “once a year”. The Fed's rate hike is turning into a Christmas present of sorts, and then the first quarter is spent trying to recover from the cost of the present.
The situation facing the Fed is surprisingly difficult. On one hand, inflation seems to be creeping higher, labour markets are doing reasonably well and stock prices are close to all-time-highs. The growth outlook has recovered from a dismal early 2016. The logic of hiking rates now to have more leeway later, and the opportunity of being able to do so now, both support a rate hike.
On the other hand, very recent economic data has been weak; Brexit might still become a shock if political reasons dictate tight negotiation stances and, most importantly, Donald Trump might win the US presidential election on November 8. It would be much less risky for the Fed not to hike, but instead signal that a December hike is firmly on the table.
The Fed’s dot-plot – the consensus view of the future path of rates – has until now seen two more hikes in 2016. It is likely that the dot-plot will be adjusted so that only one hike in 2016 and a correspondingly lower trajectory in the coming years will be seen.
Sure, again missing the opportunity to hike rates could be interpreted as the Fed’s loss of control, but with the futures markets implying only a 20% chance of a rate hike this week, it would not be a surprise. In fact, a rate hike now would be unexpected and a sign that the Fed really sucks at providing forward guidance.
To the Federal Open Market Committee, giving investors a tad dovish and indecisive image of itself is a smaller danger compared with hiking ahead of a big-risk event and losing investors’ faith in the predictability of monetary policy.
If there will be no rate hike, and the consensus view really isn’t expecting one, what are the implications for investors?
The current market-implied probability for no rate hike in 2016 (even at the December meeting) is 45%, one rate hike 45%, and only 9% for two rate hikes.
The general view is that no rate hike on Wednesday would be bearish for the USD, and the technicals seem to confirm this possibility.
There is room for the EURUSD to move slightly higher, but the pair is close to the 1.1350-1.1500-area. EURUSD has during the 2015-2016 range not tended to last very long that high. Visits to that area have usually pushed the pair lower within a week. It seems like the 1.12-1250 area is about as high as we would reasonably get:
The key, therefore, will be interpreting the Fed policy statement and Janet Yellen’s comments on how much the bank wants to prepare the investors for a December hike. Quite possibly the forward guidance for a December hike will be delivered later in the meeting’s minutes and in speeches by Fed officials.
The above sounds like the Fed's decision not to hike would be bearish for the USD short-term, but bullish in the medium term. If the Fed decides to hike in September, the Fed would be much more hawkish than is previously thought, and USD would strengthen. If the Fed does not hike in September, but signals it will hike in December, the USD would eventually strengthen. Only if the Fed does not hike in September AND signals the December hike remains “only an option” would there be more serious dollar softness.