Fighting the Fed?

Thierry Million
Written by

17th February 2016

The Bank of Japan (BOJ) surprised the markets with a reduction of interest rates it pays on current account deposits from +0.10% to -0.10%, thus introducing a negative interest rate policy. This is a decisive regime change, as the BOJ can cut IOER (interest on excess reserves) further, in addition to the volume of money and the quality of assets that the Bank purchases. The main reason why the BOJ announced the negative IOER was to be preemptive, in order to restore its credibility and to prevent inflation expectations from falling amid the growing instability of the global economy.

The transmission channels of this negative rate policy need to be watched carefully. We have seen the entire bond yield curve drop massively, as banks have become reluctant to sell Japanese Government Bonds (JGBs), given the cost of excess reserves. The shift in BOJ policy will also reinforce Japanese investors’ foreign bond purchases, dragging global yields lower. Bonds trading with a negative yield have risen to all-time high, now accounting for 24% of the JPM Global Government Bond Index. This expansion of the universe of negative yield is creating problems for the European Central Bank (ECB). A growing amount of German bonds are trading far below the ECB’s deposit rate, making them ineligible for QE purchases.

Central Banks know that interest rates are a key channel affecting exchange rates. On the BOJ decision, the yen lost 2.5% against the dollar. However, interest rates in many other nations are already low. In the US, the weakening economic figures have postponed the FED hike cycle to next year, according to the pricing of the Fed Funds curve. Therefore, rate differentials between Japan and other countries are less likely to widen. In reaction, the USDJPY has strengthened back to 116, the level prevailing before the BOJ decision. The ECB is also trapped. President Draghi stressed at his last conference that there are “no limits” to the use of the ECB’s policy instruments. Since then, the euro has unfortunately strengthened by 4% versus the dollar. Additionally, the competitive devaluation game is also complicated by the weakening of the renminbi orchestrated by the PBOC.

Actions speak louder than words, but Central Banks, contrary to what they say, have little ammunition left. They face an erosion of their credibility as investors are getting doubtful on Central Banks’ ability to reach their targets. Inflation expectations assessed via the five year/five year inflation swaps are endlessly trending down to record lows, despite central bankers’ commitments. They have relied too much and for too long on monetary policy to tackle a structural shortage of aggregate demand. This stimulus is the drug to which the world economy and the markets have become addicted. It seems to take larger and larger infusions to make the economy feel normal. So far, the markets still respect the motto “Don’t fight the FED” (or the ECB or the BOJ…) but for how long?

All data sourced to Allianz Global Investors as at 15.02.2016

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