When will equilibrium return? That's up to FOMC, ECB and BoJ

• The Federal Reserve holds about $4 trillion of marketable securities
  
• The balance sheets of the ECB and Bank of Japan are of a similar size to the Fed
  
• These central bankers are not singing from the same sheet on monetary policy
  
• Stocks are near record highs and bond yields at record lows, distorting FX market
  

By Max McKegg

Financial markets are tired of being constrained by central bank monetary policies and want to be let loose to fulfill their traditional role of setting FX rates, bond yields and stock market valuations at “equilibrium” levels. The Federal Open Market Committee understands the frustration and has begun to do its bit, raising interest rates and flagging the possibility, indeed probability, of balance sheet reduction by the end of this year.

But while the Fed is slowly draining the punchbowl, the European Central Bank and Bank of Japan keep topping it up again, so no one wants to leave the party just yet. Stocks remain close to record highs and real bond yields at record lows, in turn distorting the FX market.



The balance sheets of the FOMC, ECB and BOJ are of a similar size and until they are all singing from the same song sheet, the best that can be said about global quantitative easing is that this is not the end, it is not even the beginning of the end, but it is perhaps the end of the beginning – to borrow from a famous wartime phrase used by Winston Churchill.

The hindrance in all three cases is a failure of inflation to follow the “Phillips curve”, that is, to rise as unemployment falls.

The US, Japan and Germany are at full employment by most measures yet in each country core inflation remains subdued. Achieving the 2% target on a sustainable basis as much a pipe dream as ever. June’s slight improvement in the Eurozone was caused by temporary factors (“German package holidays”) and looks set to drift back under 1% this month. And despite putting on a brave face, central bank officials admit core inflation in Japan will remain close to zero “in the meantime”. As for the US, as the following chart shows, for the Fed the trend is no longer a friend.

Core inflation, in the US, the Eurozone and Japan














Source: AMP Capital. Create your own charts with SaxoTrader; click here to learn more.

The minutes from the June meeting of the FOMC said that inflation was being held back by “idiosyncratic” factors (meaning particular to the US; quirky, or unusual). One cause that shows up in the statistics is a price war among wireless data providers. The heavyweights on the Committee – chair Janet Yellen, vice chair Stanley Fischer and New York Fed President William Dudley – see these influences as “transitory”.

But because one idiosyncratic factor seems to replace another on a regular basis, the minutes show the Committee as a whole is divided on when to begin winding back the central bank balance sheet. The Fed holds about $4 trillion of marketable securities, similar in size to the European Central Bank and Bank of Japan.

Balance sheets, Fed, ECB and BoJ



















Source: Thomson Reuters


The Bank of England’s contribution is not large in the scheme of things, but put in context is significant for the UK financial system. As the following chart shows, the bank owns close to 40% of the total government bonds on issue, not far behind the “world champion” – Japan.

National central bank holdings
















Source: Wall Street Journal

The markets might be champing at the bit to get on with the job of bringing prices, rates and valuations back to equilibrium but central banks are still calling the shots, and until all three give firm signals the days of super-loose monetary policy are over, markets will remain constrained. The next opportunity for one of the two big players to signal their intentions comes on July 20 when both the Bank of Japan and ECB policy making boards hold review meetings.

The BoJ event will be particularly significant because it coincides with release of their quarterly economic forecasts. The post-meeting statement from the ECB will give the full board an opportunity to endorse, clarify or even reverse the “reflation” sentiments expressed by President Mario Draghi last week.

After the BoJ and ECB have had their say the FOMC will take centre stage on July 26. As shown in this chart, the market has its doubts about the Committee’s flight path co-ordinates for the federal funds rate (the “dot plots”). Traders don’t take seriously the prospect of a 3% rate in 2019. Based on recent speeches, its appears some of the members are starting to get cold feet as well.






















Source: Bank of New Zealand

European Central Bank chief economist and executive board member Peter Praet said this week that “patience and persistence” was required if the ECB was to achieve its inflation objective.

The same will be required of traders. The opportunity to reset financial market prices – perhaps sharply – will come in due course, but not until each of the three major central banks signals their willingness to let the games begin.
 
 
– Edited by Robert Ryan

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Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.