Does dovish rhetoric from Europe's ECB, continued stimulus from China's PBoC, the reluctance of Japan's BoJ to step up QQE despite headwinds, New Zealand's RBNZ policy being put on hold signal a soon imminent Fed rate hike?
This has been on our minds since more than 2 weeks ago, when ECB head Draghi unleashed yet another canary to charge at a deflationary spiral in the single currency bloc.
While correlation might not necessarily be causation, especially in the ubiquitously tangled web of central banking, we believe this development is too significant to turn a blind eye on.
Ironically, market-based odds for a December Fed rate hike have never been higher. Based on the facts we currently know about, the fed funds futures market places approximately 58% probability of a move in December. With ever additional bit of positive macro economic data, expect these odds to inch higher.
Yes, we've been talking about no Fed liftoff in 2015 here on these pages. Regular readers might be confused at this stage, as to what exactly our point is. However, also remember we said that we were always willing to flip sides and change our biases whenever new information arrives.
Precisely this has happened, and so we're slightly altering our stance. A 2015 Fed rate hike is possible. And if it's going to happen, December is when it will.
Hawkish October after dovish September
The Fed was just a few days shy of Halloween, a few days early in spooking the global financial markets yet again, the bond markets in particular. It's already common knowledge that central banks, those oh-so-powerful institutions that dictate where financial markets trade at, are the single most influential factor of asset prices.
One would have been led to believe that post September's uneventful FOMC meeting, the narrative would have spared us the scribble, instead offering us more meat on the ribs. Said narrative of forgetting about a 2015 rate hike following September's disastrous U.S. NFP jobs report, which came after that FOMC meeting. We've too had our brains reworked in the past few days.
Why? Because October's FOMC statement was the polar opposite of that a month earlier. As a quick reminder, recall that September's statement and press conference was unarguably dovish, leaving no reference to any plausible timing of the Fed's first rate hike. 2015 rate hike odds plunged from over 50% to just under 30%, barbell-ed on December.
If September was dovish, October's statement was hawkish. This seems to be the consensus and exactly how the market has been reading it so far. The constant flip flopping by FOMC has not only ruined its credibility, but also caused great confusion amongst other central banks.
Key takeaway points from October's FOMC statement:
- FED REMOVES LINE THAT GLOBAL DEVELOPMENTS MAY RESTRAIN GROWTH
- FED SAYS U.S. ECONOMY `HAS BEEN EXPANDING AT A MODERATE PACE'
- FED SAYS LABOR MARKET SLACK HAS DIMINISHED SINCE EARLY THIS YEAR
- FED SAYS RISKS NEARLY BALANCED, MONITORING GLOBAL DEVELOPMENTS
- FED SEES SOLID GAINS IN HOUSEHOLD SPENDING, BUSINESS INVESTMENT
- FED SAYS SURVEY-BASED MEASURES OF INFLATION OUTLOOK REMAINED STABLE
- FED REPEATS IT SEES INFLATION RISING TOWARD 2% IN MEDIUM TERM
- FED SAYS PACE OF JOB GAINS `SLOWED,' UNEMPLOYMENT `HELD STEADY'
- FED REPEATS HOUSING IMPROVED FURTHER, EXPORTS BEEN `SOFT'
So basically, the FOMC has for the first time ever, mentioned that they will evaluate, based on data, the prospect of raising rates during their December meeting, making the chance of it actually happen higher.
A "live" meeting as Yellen terms it. The Fed acknowledges that the pace of jobs creation has slowed but remains robust, while the labor market is still on track to full employment, with diminishing slack.
They also removed the reference to negative external developments which had previously been linked to weakness in China and instability in global financial markets and asset prices. They seem to be confident in achieving their long term inflation target of 2%; now that oil prices have stabilized somewhat, this analog has gained ground.
Furthering the throw of last Thursday's hawkish statement, Yellen spoke the words bond investors had feared when she testified in the U.S. senate on Wednesday. Bond yields have since exploded after last Thursday's statement, as has the entire yield curve been floated by this sudden shift in tide.
Here are some of the rather hawkish bulletin points from Yellen's congressional testimony (Wednesday):
- YELLEN SAYS SHE SEES U.S. ECONOMY AS PERFORMING WELL
- YELLEN SAYS SHE SEES LABOR SLACK DIMINISHED SIGNIFICANTLY
- YELLEN SAYS FOMC THOUGHT IT COULD BE APPROPRIATE TO MOVE IN DEC
- YELLEN SAYS NO DECISION MADE ON DEC. MOVE, DATA TO BE MONITORED
- YELLEN SAYS DEC. WOULD BE `LIVE' MEETING IF DATA SUPPORTS MOVE
- YELLEN SAYS FED EXPECTS ECONOMY TO JUSTIFY GRADUAL TIGHTENING PACE
While the Fed has been good at the game of bluff all the way since last year, promising a path of policy tightening but never actually doing so, the market is clearly pricing in a one way outcome as the days pass and December's meeting draws nearer.
Central banks can't all tighten at once
They just can't. Or else the delicate house of cards that is the global financial markets and system get razed. If we look back in recent history, for every central bank that was on the path of policy tightening, sustained or not, there was at least one other that was easing or maintaining its loose policy.
This brings us back to our original point. Do central bankers know something about the Fed's near term actions which the general market doesn't?
Perhaps, and one shouldn't undermine how much insider chit chat goes on behind the scenes. Central bankers are always in constant communication within their individual loops. If anyone knows what the other will do, it's probably them.
Draghi is keen on doing more of the same, ramping up the ECB's PSPP (QE), and maybe even lower the deposit rate further. Very much dovish, and the euro has plunged without looking back for the past 2 weeks. Goldman expects EURUSD to trade at 1.02 before Christmas.
The PBoC proceeded in cutting interest rates and lowering bank funding requirements a day after Draghi dropped his dovish bombshell, like a faithful dog returning a bone. We spoke about this in brief in one of our snippets.
The BoJ, despite heightened expectations of more QQE, stayed firm last week, disappointing markets. Reason? Kuroda commented that the BoJ expected the U.S. dollar to remain strong, which helps the yen remain competitive globally. The BoJ did however raise their inflation target to 3%, which can be considered dovish in certain aspects.
The RBA (Australia) and RBNZ (New Zealand) both maintained their stance without mentioning anything different than to comment that a strong U.S. dollar had so far been a positive for their economies and exports, and that falling commodity prices will continue to exert downward pressure on the aussie and kiwi dollars. Do they know that the Fed will liftoff in December? Maybe.
All these seems to us more signal than noise.
Remember how the SNB's move to unpeg the Swiss franc from the euro days before the ECB officially launched its monumental €60bn/month QE program? Does one really believe that unforgettable episode happened by chance and coincidence? Or did the SNB already know long before the markets started discounting reality
We'll leave this up to you to decide. The proof is in the pudding, and this one's pretty dense. So take it for what it is, we're playing it cautious but not holding our breaths.
Bonus analysis from the big banks
RBS' take on the ECB's (and European CBs in general) future path of monetary easing, including the expansion of scale and breadth of asset purchases:
"Yesterday the ECB prepared the ground for more easing in December, as we expected. What was surprising was the post-meeting Q&A, which went into more detail on the possibilities for easing, and even made a direct comparison with the Swiss National Bank – currently the central bank with the largest balance sheet as % of GDP (90%) in developed markets.
All options considered means non-financial credit, wholesale loans, subsovereigns, and even equities. We have already outlined that expanding purchases to other types of credit could theoretically double the pool of the ECB’s purchasable bonds, to almost €19tn.
Adding more utilities or state-backed corporates is a logical step, but it is not going to give the ECB much further room. The ECB could decide to go further into the pool of € non-financial corporate bonds (€893bn) rated BBB and above, including € bonds from non-Eurozone issuers (€687bn excluding non-Eurozone issuers). Adding equities would be particularly aggressive, offering a further €7tn of purchasable assets.
Sub-sovereign bonds are another option, adding €336bn of local government bonds to the pool of assets. Sub-sovereign bonds account for around 3% of Eurozone GDP (this is small compared with the US, where municipal bonds are 21% of GDP).
One incentive for the ECB to launch the ABS purchase programme last year was likely to encourage securitisation, helping banks to deconsolidate their balance sheets and unlock new lending. But securitisation issuance hasn’t picked up (see SIFMA data). This is partly due to the lack of harmonisation of national-level rules, the harsh capital treatment even for simple securitisations and the lack of government support (no guarantees to mezzanine tranches, even though the ECB can now buy guaranteed mezzanine tranches through ABSPP). Given the stagnant developments in the securitisation market, the ECB could instead start to buy loans directly to better target easing at the real economy. There are practical hurdles to loan purchases – illiquidity, lack of transparency, long settlement periods.
The SNB has a balance sheet equivalent to 90% of GDP, the highest amongst major developed economies (see chart above). Taken that as a theoretical ceiling, the ECB could further expand its balance sheet by another 70% of GDP, i.e. over three times what they have done so far."
And more analysis on the ECB's latest hints from Goldman Sachs:
"ECB President Draghi today put additional monetary stimulus, above and beyond the measures announced in January, on the map for the December 3 meeting. In particular, he raised the possibility of stepping up the existing QE program and / or cutting the deposit rate further. EUR/$ moved substantially lower during the press conference (Exhibit 1), but we argue in this FX Views that potential downside is still substantial. As we noted in our FX Views earlier this week, we think a 10 bps (surprise) deposit cut is worth two big figures downside in EUR/$. We base that assessment on empirical work we did last year and the September 2014 surprise deposit cut, when EUR/$ fell around two big figures (Exhibit 2). At the very least, following today’s press conference,a December deposit cut is now possible, meaning that EUR/$ – which went into the meeting at around 1.13 – should reprice to 1.11. Of course, there is a good chance that December will instead bring an actual augmentation of the QE program, such that downside in EUR/$ might be larger. The kind of scenarios our European economics team envisage imply downside of at least 5-6 big figures from here, i.e. should see us return to near the 1.05 low that EUR/$ made in March.
From a fundamental perspective, we have argued all year that additional stimulus from the ECB is needed and will come, which formed the basis of our downward revision to our EUR/$ forecast back in March (when we switched to 0.95 in 12 months from 1.08 previously). We developed conviction in our call over the summer, when we showed that developments in the Euro zone, in particular structural reforms on the periphery, look like they are shifting down the Phillips curve, making it harder for the ECB to bring inflation up on a sustained basis. As we argued earlier this week, the Bund sell-off that began in May was harmful to ECB QE, but we think the trend now will be to fix the credibility of the program. Today’s meeting was indeed “decision time” for the ECB, as we had hoped.Given that shift, we think there is plenty of scope for EUR/$ downside from here, in line with our forecasts."
Barclays and Deutsche Bank on imposing negative interest rates (NIRP) in Europe:
"A cut in the ECB’s deposit rate further into negative territory likely would have a significant impact on the EURCHF exchange rate and provoke a more immediate response from the SNB. Indeed, we expect that a cut in the ECB’s deposit rate may have a greater effect on EURCHF than on other EUR crosses. Switzerland applies its negative deposit rate to only a fraction of reserves, currently about 1/3rd of sight deposits by our calculation. In contrast, negative deposit rates apply to all reserves held at the ECB, Riksbank and Denmark’s Nationalbank. Consequently, a cut to the ECB’s deposit rate likely has a larger impact both on the economy and on the exchange rate than a proportionate cut by the SNB. An SNB response to an ECB deposit rate cut could take one of two forms: 1) a further cut in its deposit rate and CHF Libor target range; or 2) the ‘nuclear’ option, removing all exemptions from the negative deposit rate. We think the latter is more likely and would have major implications for EURCHF." Most retail (private) depositors at domestic Swiss banks still do not face negative interest rates, but we would expect that to change if the SNB removed exemptions of domestic banks on sight deposits at the SNB. A removal of domestic banks’ exemption from negative deposit rates likely would force Swiss banks to pass on negative deposit rates as it would increase the proportion of assets charged negative rates to over 20%.
The main concern with further cuts to policy rates is the problem of the zero lower bound. In academic literature, the challenge for central banks operating near or at zero interest rates is that it is technically unfeasible to impose interest rates on cash. Depositors charged at negative rates can simply exchange electronic reserves into paper currency.
As well as losing control over monetary policy, central banks would see financial conditions tighten as banks were forced to sell assets to meet depositor withdrawals. In extremis, the effect could be compared to a bank-run preceding capital controls or large scale currency devaluation. However, due to the more incremental nature of the impact of negative rates (e.g. 25bp charge on deposit holdings rather than a multi percent devaluation), interest rates would need to be slashed deeply negative for depositor withdrawals to resemble much more than a jog.
So far, the experiences of the four European economies under negative interest rates, including the Eurozone, suggest that this theoretical constraint has not been reached. The demand for coins and notes has ticked up slightly in recent months, but remains at fairly muted levels.
Why the lower bound constraint has yet to be reached, and how much more room there is to maneuver, is obviously crucial for the ECB and the three other central banks imposing negative rates. The main reason is that banks have not passed on negative policy rates to depositors. In none of the four economies are household deposit rates in negative territory, either for outstanding balances or new business. Why have negative nominal rates not passed through to depositors?
Banks are very reluctant to pass on negative rates to households because retail depositors are least likely to understand the wider monetary policy context behind such a decision.
The SNB have noted that the consequence of introducing negative rates earlier this year was rising, not falling, mortgage rates as banks sought to protect falling liability margins by raising long-end rates. In a similar vein, Danish banks appeared to raise administration fees on new mortgages after rates first turned negative back in 2012. An analysis of long-end mortgage rates offered by banks across Sweden, Denmark and Switzerland suggests that at the long-end, rates have actually risen since the introduction of negative interest rates."