Following quiet trading sessions on both Monday & Tuesday, Wednesday always had the likelihood of seeing increased volatility, with two key risk events on the calendar, being both the Bank of Japan & Federal Reserve monetary policy decisions. Traders were not disappointed, with the S&P 500 gaining over 1%.
The Bank of Japan left its key interest rate unchanged at -0.1%, however announced a change to its policy framework following a comprehensive review into the effects on prices of its negative interest rate and QQE policy. The bank announced that it would switch from targeting an annual expansion of the monetary basis to controlling the yield curve, specifically with a short-term rate at -0.1% and ten-year bond yield around 0%.
This comes from the review which showed that short and medium term interest rates have a larger impact on economic activity as opposed to longer-term rates while at the same time flattening the yield curve was likely having negative effects on the financial sector such as banks and insurers as well as people’s sentiment. Effectively, what this new approach will do is steepen the yield curve, not to be confused with a tighter monetary policy. The bank will focus on keeping short to medium term rates low while allowing longer-term rates i.e. those greater than ten years, to rise to more normal levels, which is key to the functionality and profitability of banks and insurers.
The statement also firmly noted that the positive effects from negative rates were outweighing any negative impacts and expressly stated that the bank was willing to cut both the short and long (ten-year yield) rates if necessary, expand asset purchases under its QQE program or accelerate the expansion of the monetary base. This is a firm response to recent market sentiment that central banks are running out of ammunition or at the limit of their policies, it sends a clear message the BOJ will press on and do what it takes to achieve its 2% inflation target. The bank will also adjust current ETF purchases to focus more broadly on the Topix index as opposed to just the Nikkei 225 in order to remove some of the distortions created by this policy, to give you an idea it is estimated the BOJ is the no.1 shareholder in 55 of the Nikkei225 companies.
Finally, regarding inflation expectations, the bank has adopted a commitment to overshoot the inflation target in order to “strengthen the forward-looking mechanism” that forms inflation expectations. As they have consistently undershot this target, in order to achieve the 2% target on average over the business cycle they will then need to overshoot in the future to account for this. The idea is that by committing itself to expand the monetary bases until CPI exceeds the 2% target and “stays above the target in a stable manner” they are looking to change the mindset of the Japanese public around inflation expectations, by saying they will have higher inflation in the future the public then expects this and spends more today as their money will purchase less in the future.
Will this work? Only time will tell but overall I think this sends a very positive message to markets and the public, that they are not at the limits of their policy and they recognise the negative impacts of their extraordinary policies and they are acting to limit these negative side effects. Markets reacted positively to the news, with equity gains led by banks and insurers as both the Nikkei & Topix gained +1.91% & +2.71% respectively. Yields on both two and ten-year government debt rose 3.8 & 3 basis points to -0.222% & -0.023% respectively while the Yen initially weakened against the U.S. dollar. The first chart below shows the reaction across both the USDJPY & Nikkei225 index.
Across to the U.S., and the FOMC kept the Fed Funds rate unchanged at 0.25-0.50% while setting the stage for a rate hike in December. The statement along with the announced noted that the “labour market has continued to strengthen” and “growth of economic activity has picked up”. While business investment has remained soft with inflation below the 2% target “household spending has been growing strongly” and inflation is expected to reach 2% target over the medium term. While noting that “the committee judges that the case for an increase in the federal fund rate has strengthened” near-term risks to the economic outlook were balanced and the committee has therefore decided “to wait for further evidence of continued progress toward its objectives”.
Aside for no significantly disappointing data between now and December it looks very likely that we will see a 25 basis rate hike which is confirmed by the Fed’s updated economic projections or “dot plots” shown on the second chart below. The median estimate signals that the fed funds rate should be between 0.50-0.75% by the end of 2016 or the equivalent of one rate hike. What is interesting is that the Fed has lowered in 2017 projections for three hikes at the June meeting to just two now, signalling an even slower and more gradual rate hike cycle that previous estimated which is now expect to peak around 2.9% as opposed to 3% as forecast in June.
Unsurprisingly, Esther George of the Kansas City Fed dissented wanted to rate rates by 25 basis points similar to July,interestingly not one but two other committee members joined in dissenting. Both Cleveland President Loretta Mester and Boston President Eric Rosengren have now joined in wanting to raise rate showing that momentum is now clearly shifting towards the more hawkish camp of the Fed adding weight to the view of a December rate hike.
In reaction, the U.S. dollar weakened as the prospect of less hike in 2017 lowered demand for the currency, the U.S. dollar index fell -0.56%. At the same time equity markets rallied with both the S&P500 & Nasdaq100 gaining +1.09% & +1.01% respectively, all ten sectors of the S&P500 finished higher for the session led by gains in Energy (+2.13%), Utilities (+2.10%) and Basic Materials (+1.73%). The yield on two-year government debt initial rose as much as 7 basis points following the meeting before finishing relatively unchanged at 0.7784% while the yield on ten-year securities declined -3.2 basis points to 1.6546%.
The weaker dollar helped boost commodity prices broadly, both Crude Oil & Brent crude oil gained 2.93% & 2.44% ahead of an informal meeting between both OPEC and non-OPEC producers next week in Algeria at the same time as U.S. crude oil inventories declined 6.2m barrels for the week finishing September 16th against expectations of a 3.25m barrel increase. Copper prices finished flat, down just -0.02%, natural as gained +0.33% as did the Thomson Reuters CRB index up 1.03%. Precious metals spot gold & silver benefited significantly from the weaker dollar, up +1.66% & +2.80% respectively.
Locally the S&P/ASX 200 finished +0.68% higher and the market looks set to open higher this morning with ASX SPI200 futures up 32 points in overnight trading.
Data releases:
- ECB Economic Bulletin 6:00pm AEST
- U.S. Continuing & Initial Jobless Claims (Sep 10th & 17th) 10:30pm AEST
- U.S. Existing Home Sales (MoM Aug) 11:00pm AEST
- U.S. House Price Index (MoM Jul) 12:00am AESt
- Euro-zone Consumer Confidence (MoM Sep) 12:00am AEST
- U.S. Leading Indicators (MoM Aug) 12:00am AEST
This article was written by James Woods - Global Investment Analyst, Rivkin Securities Pty Ltd.
