Major macro risks so far this year have had mostly temporary impacts on markets, all while monetary policy has evolved from accommodative toward restrictive. I still believe the shift in policy (and the accompanying shift in US dollar liquidity) is ultimately the dominant driver of markets. The performance of risk assets and interest rates in the month since my last commentary provides an interesting case in point. Subtle changes in the monetary policy outlook, which were effected almost entirely by Chair Powell, drove markets more than macro risks. Today I’ll recap both macro and policy evolution, which is pretty striking when viewed all together, and then shoehorn it into the Three Phases Model to get a near-term outlook for further market performance.
The list of macro risks was pretty long and it got longer. You probably noticed each of these when they surfaced, but collectively October has a pretty unappealing macro backdrop:
Separately from all of this, Fed Chair Powell made several appearances since his unnecessarily dovish August speech in Jackson Hole. Rather than definitively walk back that dovishness, his various comments were hazy and lacked a clear message.
At times he was dovish: “the main thing where we might need to move along a little bit quicker would be if inflation…surprises to the upside. We don’t see that. We really don’t see that. It’s not in our forecast….”. “[T]he rise in wages is broadly consistent with observed rates of price inflation and labor productivity growth, and therefore does not point to an overheating labor market.”.
He does not see it to be in the interests of the Fed to slow down growth to regulate inflation, despite slow potential growth at full employment: “So if the economy is weakening, then it’s very possible we’d be cutting rates.” And he does not expect growth to slow until the end of the tightening cycle. Responding to a journalist question “[do you see] any kind of specific sign posts that we’ve reached the end of the tightening cycle?” Chair Powell said “…You know if headline growth slowed down.”.
At times he was hawkish: “Interest rates are still accommodative, but we’re gradually moving to a place where they’ll be neutral…. We may go past neutral. But we’re a long way from neutral at this point, probably.”.
He continued to reiterate that the committee does not know where the neutral interest rate (r-star) is, nor does it care: “we don’t want to suggest that either we have this precise understanding of where accommodative stops or suggest that that’s a really important point in our thinking…. [T]hat does kind of amount to thinking less about one’s precise point estimate of the neutral rate. So that’s how I think about it.” Notwithstanding that the SEP dots are fairly consistent in the point estimate of long-run neutral, Powell went on to say: “we have to be humble about how little we really know about where these starred value variables either are or are going.”.
There was also some cheerleading of the strong economy, which ultimately resulted in a roundabout declaration that he could soft-land the economy: “Indefinitely is a long time…not every business cycle is going to last forever, but no reason to believe this cycle can’t go on for quite some time, effectively indefinitely.”. Of course, no business cycle has ever lasted indefinitely, and at the September press conference he side-stepped a question about whether he would need to cut rates to soft land the economy.
Ultimately, Chair Powell increased the uncertainty of the policy rate path all else equal, even if not increasing the uncertainty of the Fed’s reaction function. By undermining market confidence in the Fed’s own estimates of the long-run neutral rate, more uncertainty was necessary in market pricing for that neutral rate and ultimately the terminal rate on the current hiking path. Naturally, that uncertainty manifest itself in risk to the upside in the terminal rate, so the 10-year yield went higher and the curve steepened. In practical terms, marginal sellers of Treasury bonds were encouraged to do so.
This move to higher 10-year yields was at least as important a driver of all risk markets as the list of macro risks, and I think the underlying implications for monetary policy of the former (greater uncertainty) will persist for a bit longer. The fact that we had a material rise in long term rates in the beginning of the month of October is important, because October is the month where Fed QT steps up to $50bn per month, and ECB QE steps down from EUR30 to 15bn per month. October is the first month where global G4 central bank balance sheets are now likely shrinking in aggregate.
As a result, I believe the combination of increased interest rate policy uncertainty and accelerated balance sheet reduction has kicked off a mini-Three Phases cycle afresh, as in back to Phase 1. Financial conditions tighten in a fairly uniform way: interest rates go higher, stocks weaken, spreads widen, volatility increases, and the dollar strengthens. It wasn’t perfectly choreographed but generally in the first 10 days of October we have seen Phase 1-type price action, and the Goldman Sachs Financial Conditions Index responded accordingly, reaching the tightest conditions of the year so far. My expectation from here forward is a continuation of the Three Phases in miniature, i.e. next we could see a repeat of the transition from Phase 1 to Phase 2, as the market anticipates the impact of tighter financial conditions on underlying economic performance. Risk assets will stay kind of weak, but Treasurys will rally a bit in a resumption of regular negative correlation between stocks and bonds. It may very well be a macro event which triggers this – back in May of this year, the Italian political crisis was the catalyst for resumption of right-way correlation between stocks and bonds. Then, once there is concern that tighter conditions may impact the economy, the Fed will respond, perhaps offering some clarity on how far until neutral, and emphasizing whether they are planning to pause at neutral. That’ll kick off Phase 3 of the mini-Three Phases, a relief rally in risk and interest rate backup, which may also establish itself as Phase 3 of the major full-year timeframe we have analyzed in these pages so far this year.
 Sep. 26, 2018 FOMC Press Conference: https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180926.pdf
 Oct. 2, 2018 speech to NABE: https://www.federalreserve.gov/newsevents/speech/powell20181002a.htm
 Oct. 3, 2018 interview at the Atlantic Festival: https://www.theatlantic.com/politics/archive/2018/10/federal-reserve-chair-jerome-powell-ignoring-trump/572110/
30yr JGB yields have risen close to 30bps since July this year. As a result, in less than three months, the 10s30s curve has unwound almost all of the flattening that had occurred since the middle of last year. This selloff is not in isolation – US 30yr Treasury yields have risen close to 45bps since late August. However, it was the changes that the BoJ made back at its July meeting that have allowed long end JGB yields to become more connected with moves in global duration.
What are the BoJ trying to do?
At their July monetary policy meeting, the BoJ tweaked their policy to make it more sustainable given their view that it will take much longer than expected to reach the inflation target of 2%. In order to the limit the side effects of their policy, they allowed more flexibility around the 10yr target by widening the range to +/- 20bps.
Quantitative and qualitative easing (QQE) with yield curve control has limited both the activity and volatility in the JGB market. By allowing for more flexibly in their policy, the hope is that JGB yields can once again reconnect with domestic and global fundamentals, allowing long term yields to be more market driven. However, the implicit conclusion is that the BoJ wants a steeper curve, given the lobbying pressure from banks with declining interest margins. Concerns have been consistently raised by those both inside and outside the BoJ that a flattening yield curve was damaging margins and hurting financial intermediation.
Can the BoJ steepen the curve?
The BoJ are unlikely to make a steeper curve an explicit policy given both their desire for the curve to be more market driven and the fear of a stronger currency hampering their inflation objective. Nonetheless, they are currently adjusting their QE purchases to encourage a steeper curve. Although their stated policy is to expand the monetary base by 80tn Yen per year, this flow has been on a declining trend for some time as they shift
their focus towards their price target (Figure 1). The decline in purchases has not been equal across the curve, with the bulk of the decrease coming from the long end (Figure 2). They recently reduced their target purchases in the >25yr sector once again, reflecting their implicit desire for a steeper curve.
At the same time, the Government Pension Investment Fund (GPIF), one of the largest holders of JGBs, have also tweaked their investment policy which reduces the urgency for them to buy JGBs.
Will it work?
The combination of these factors does imply a steeper curve. However, the policy should not be viewed in isolation. If global bond yields are rising, JGBs yields may trade with a higher beta than the post-crisis norm. But do not expect the curve to steepen in the absence of a global selloff. The main reason is that whilst the BoJ are looking to limit the side effects of monetary policy, they are more concerned with their inflation target. If they attempt to push long term bond yields up without a backdrop of higher yields elsewhere, the currency is likely to strengthen.
There are other important limiting factors. The BoJ already holds over 50% of the bond market below 10yrs (Figure 3). They will eventually need to reduce purchases in these buckets if net supply (including QE) remains negative.
Secondly, the GPIF are not the only large holders of JGBs. Due to a combination of low JGB yields and BoJ purchases, city and regional bank holdings of JGBs are through a pre-crisis low. Any further steepening in the curve, may induce these domestic buyers back into the market (Figure 4).
This is especially relevant given the globalisation in yields that has occurred since the start of QE. Despite the fact that the flow of QE is starting to turn negative, the stock of bonds on central bank balance sheets will remain high. Hence, any steepening of the JGB curve in isolation will quickly be unwound by the global search for yield. In fact, the 10s30s JGB curve is already the steepest in the G4, partly due to the fact that the curve up until 10yrs is held down by yield curve control. More importantly, once you adjust for the cost of hedging*, 30yr JGBs are still more attractive than Treasuries.
Furthermore, it is questionable whether a steeper curve will actually improve banking profitability. After all, at the most basic level, higher yields represent tighter financial conditions. Right now, the BoJ’s Tankan survey does not show any problems with financial intermediation. In fact, it remains close to cyclical highs. Interestingly, the BoJ themselves (in the April financial stability review) concluded that half of the fall in income margins is due to structural factors (i.e. demographics and overbanking). As for interest rates, it is the outright level of interest rates that impact bank earnings rather than the steepness of the curve specifically. Raising the 10yr target would likely boost income via increasing interest rates on new loans (Figure 5) with deposit rates sticky at 0%.
Overall, there are lots of impediments to a steeper curve. Hence the policy shift at the BoJ should be viewed in the context of global duration. Importantly, for Japanese long term bond yields to sell off in isolation or be the cause of a global steepening, it must be driven by domestic fundamentals – i.e. growth and inflation.
That said, the policy change at the BoJ is still significant since it allows long end JGBs to participate far more in global yield movements. At the very least, this removes one impediment to higher rates globally.
* Based on a 3 month FX hedge