Markets & Economy
Central Bank Watch: A Hawkish Hold, a Dovish Hike, and Implications for Financial MarketsMarch 28, 2017 Nikolaj Schmidt, Chief International Economist
- The G3 and UK central banks all recently held policy meetings against an apparent backdrop of strong growth and rising inflation. However, the bulk of the growth is being driven by “soft” data, and the acceleration in inflation is mostly due to rising commodity prices in the fourth quarter of last year.
- Central banks are tiptoeing toward tightening: We still expect the Fed to deliver three hikes this year, we do not expect any hikes from the European Central Bank (though it may taper asset purchases next year), and Japan is unlikely to consider raising rates until autumn.
- We believe that currency and bond markets that offer meaningful yield pickup will perform, which implies that emerging markets will continue to deliver.
- However, we also believe that growth figures will need to be closely monitored for any changes in momentum—monetary tightening in a slowing growth environment would produce a very different market response.
The G3 and UK central banks all recently held policy meetings against an apparent backdrop of strong growth and rising inflation. However, the bulk of the growth is being driven by “soft” data such as improving consumer sentiment and business confidence (hard activity data, such as industrial production and retail sales, paint a more subdued picture), while the acceleration in headline inflation is mostly due to the rise in commodity prices in the fourth quarter of last year. Central banks are tiptoeing toward tightening. Does this spell an end to the rally in risk assets? We don’t think so.
The European Central Bank (ECB) was first in action. On the back of strong activity data, the market has begun to ponder whether the ECB can hike interest rates while continuing its bond-buying program. The speculation makes some economic sense: By both raising rates and continuing to purchase financial assets, the ECB can tighten eurozone financial conditions, as required by Germany, while also preventing a precipitous tightening in the weaker peripheral economies.
As expected, ECB President Mario Draghi kept all monetary policy parameters unchanged but refused to rule out the possibility of the interest rate being raised prior to the end of the asset purchase program. This too makes sense: Data from the eurozone have been encouraging, but we do not see broad-based inflation pressures building across the currency area. The ECB carries a pan-European inflation mandate, and this can result in financial conditions being too loose in certain areas (Germany) and too tight in others (southern Europe). Overall, we do not believe that the ECB will be in a position to hike interest rates in 2017, but we expect it to taper asset purchases next year.
The Federal Reserve (Fed) meeting delivered a major dovish surprise. Hawkish comments from Fed speakers in the weeks prior to the meeting not only shifted market consensus toward a March hike (against the previously expected June), but also raised expectations that the Federal Open Market Committee would raise its expected path of hikes for 2017 and 2018 (the “dot plot”). However, while the Fed indeed delivered the expected hike, it did not meaningfully revise the dot plot and struck a marginally dovish tone in its monetary policy statement. We continue to expect the Fed to deliver three interest rate hikes this year and are encouraged that Chair Janet Yellen appears intent on not repeating the mistakes of the 1930s—the normalization of the balance sheet looks set to occur at a slow and well-telegraphed pace. We expect the balance sheet adjustment to become a story for the financial markets for the second half of the year.
Prior to the Bank of Japan’s (BoJ) meeting, there was speculation that the bank might adjust its policy parameters, in particular its 0% cap on 10-year government bond yields. In the event, however, the BoJ maintained all existing parameters, and Governor Haruhiko Kuroda rejected the suggestion that Japan would be forced to adjust the 10-year 0% cap or slow its asset purchase program. We believe the BoJ left its parameters unchanged because inflation expectations are backward-looking and monetary policy is close to its lower boundary. We expect that the BoJ will only adjust its policy stance when actual inflation is making a clear sustainable move toward the 2% goal. Discussions about a potential recalibration of Japan’s monetary policy stance will become much more relevant toward autumn.
What does all this mean for financial markets? Historically, a tightening of the monetary policy stance by developed market central banks has not signaled the end of the road for risky assets. Through the substantive tightening cycle from 2004 to 2006, for example, risky assets continued to rally. It is important to remember the context in which the monetary tightening takes place and the pace at which it is implemented. As shown by the market performance over the past couple of months, gradual monetary tightening amid stronger global growth does not have to be a major obstacle for risky assets. Importantly, although central banks are moving slowly toward the exit, we still live in a world where yields in the developed economies are close to zero and where liquidity is abundant. Although the former is slowly changing, liquidity abundance should continue to grow with both the ECB and the BoJ set to expand their balance sheets throughout 2017.
Despite the gradual tightening of monetary conditions in developed economies, we believe that currency and bond markets that offer meaningful yield pickup will perform, which implies that emerging markets will continue to deliver. However, we also believe that growth figures will need to be closely monitored for any changes in momentum—monetary tightening in a slowing growth environment would produce a very different market response. And of course, political uncertainty is a constant risk that could threaten the risk rally at any point.
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The views contained herein are as of March 2017 and may have changed since that time.
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