Summer Is Over

Summer Is Over

Make no mistake: The summer sedation in markets caused by dovish central bank talk and action after the Brexit vote lies behind us. Starting with the 8 September European Central Bank (ECB) meeting and press conference, global bonds have sold off, yield curves have steepened and equity market volatility has spiked. Central banks, which had been dampeners of volatility ever since the 2008 crisis started, have all of a sudden become a source of volatility as they may be less willing to underwrite markets in the coming months now that the fallout from Brexit looks contained and the long-term negative effects of extremely low interest rates on the financial sector are becoming ever more apparent.

Specifically, many investors are asking themselves three related questions:

  • When Mario Draghi said, “We didn’t discuss QE [quantitative easing] extension” on 8 September, was he signaling that additional ECB stimulus might not be forthcoming in December?
  • Could the Bank of Japan’s “comprehensive assessment” of its quantitative and qualitative easing (QQE) and negative interest rate policy (NIRP) at this week’s policy meeting result in a tapering of bond purchases in the long end of the yield curve, or even in a policy U-turn?
  • Will the Federal Reserve guide markets more clearly toward a December rate hike after its policy meeting on Wednesday?

Fed eyes data

Starting with the data-dependent Fed, while recent output and demand data have been mixed, they still point to a rebound in third-quarter U.S. GDP growth to around 3% from the sluggish 1% pace in the first half of the year. And Friday’s inflation release showed core CPI inflation ticking up one notch to 2.3% on the year in August, which could imply some pickup in the Fed’s preferred measure of inflation (the core PCE deflator) closer to the 2% target.

While the Fed is unlikely to issue a very hawkish statement on Wednesday, the dot plot of appropriate policy rates is likely to solidify expectations for a rate hike in December, once the election is behind us. Currently, market estimates place the odds of a December hike just above 50% – a bit too complacent in our view. However, any hints that a December hike has become more of a probability than a mere possibility will likely be accompanied by reassurances that the path of rate hikes in the coming years will be very shallow. This can best be signaled by a flattening of the path of appropriate policy rates over the 2017–2019 horizon in the dot plot. Yet given that markets are currently priced for a much flatter path than even a downwardly revised September summary of economic projections would show, this should provide little comfort.

ECB ponders next steps

Regarding the ECB, more easing in December still appears to be in the making, including an extension of QE beyond March 2017, a further cut in the deposit rate (currently at −0.4%) and a relaxation of the capital key to address the bund scarcity problem (see Andy Bosomworth’s blog piece on what to expect in December, and why). True, more easing cannot be taken for granted, and some of the more hawkish council members, including Bundesbank President Jens Weidmann, have started to come out arguing against more easing at this stage. However, where there is smoke, there is usually fire, and so the discussion at the ECB about further monetary relaxation and its modalities is likely to have started, despite Mario Draghi’s comment in the press conference. In any case, the guessing game will continue until December, keeping markets volatile.

Bank of Japan likely to ease policy

Finally, the Bank of Japan is widely expected to ease policy further this Wednesday, but the focus will likely be on steepening the yield curve, potentially through buying fewer bonds in the long end and more in the short end, and by cutting the official interest rate further. Such a “reverse Operation Twist” would be aimed to help the banks and insurance companies who have been suffering from the flattening of the curve and ultra-low long-dated yields. As my Tokyo colleague Tomoya Masanao puts it, it may be time for a new framework for the Bank of Japan: targeting a “New Neutral yield curve.”

Bottom line: Central banks won’t make a U-turn anytime soon, but unconditional and eternal support for markets can no longer be taken for granted as the negative side effects of unconventional policies for the financial sector and thus for the transmission of monetary policy to the economy are gradually becoming apparent. This suggests that markets are in for a bumpy ride in the weeks and months ahead. This much is certain: Summer is over.

Joachim Fels is PIMCO’s global economic advisor and a regular contributor to the PIMCO Blog.

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