Author: Alex Wolf, Yuxuan Tang, and Global Investment Strategy Team
It’s been a busy week for Central Banks: on Tuesday the Bank of Japan (BOJ) announced that it would shift from what had been a fixed cap on JGB yields at 1% to a more ambiguous 1% “reference” target. Shortly after, it was the Fed’s turn to decide on interest rates, and not letting Central Banks take all the limelight, the U.S. Treasury announced its borrowing estimate. On top of this policy news, there was also a slew of economic data giving additional signals about the path of growth and inflation. In short, a lot of news for markets to digest. As of writing, the overall result is a rally in bonds driving yields lower and stocks higher. The market is taking solace from slightly weaker data showing a continued cooling in the U.S. economy (good for inflation), the Treasury announcing plans to sell less than expected Treasuries (alleviating a key worry about supply), and the Fed staying on pause. It’s too soon to say whether this is a decisive turning point for U.S. bond yields, as the Fed maintains that it will be data dependent. If they see an acceleration in labor market activity or inflation, they could hike again. Nonetheless, in our view growth is slowing and the Fed is likely done. As the market moves to further price that in, Treasury yields could decline further.
Another surprise from the BOJ. What does their adjustment mean for global markets?
The market got a “Halloween trick” from the Bank of Japan on Tuesday in the form of a confusing meeting. It was a seemingly hawkish meeting – BOJ increased the flexibility of its yield curve control (YCC) program by effectively removing the hard 1% upper bound on 10 -year yields, and also significantly raised its forecast for inflation in 2023 and 2024 – but still quite ambiguous. The BoJ isn’t explicitly saying where it will intervene to hold down bond yields, but the move seems to be an indication that while the BOJ will allow some rate increases, it is not yet trying to give a clear signal of policy tightening. This type of stance used to make sense for the BOJ as the economy was still in the midst of recovering from COVID, now it is increasingly looking disconnected from economic conditions. The BOJ continues to forecast inflation falling below 2% in 2025 and thus it continues to argue that the inflation goal is not yet in sight. However, Japanese inflation is above the BoJ’s target, and indeed above U.S. inflation for the first time since 1977 (not counting one off wage hikes). Furthermore, strong Japanese profits look like they’re passing through to wage hikes; and growth is holding up relatively okay, even amid a softening of global growth. Going forward, policy makers could face an increasingly unambiguous choice between accepting even higher inflation and more notable currency weakness or tightening further. We continue to expect an eventual exit from YCC and exit of negative interest rate policy (NIRP) over the course of next year.
Market responses were mixed. While JGB yields were still up across the curve, the decision appears to have fallen short of FX market speculations of a bigger (or at least clearer) policy tweak, which led the yen weaker. Treasury yields reacted in a similar manner; they declined following the announcement as the BoJ’s move was perhaps was perhaps less hawkish than markets were anticipating. For the Yen, we think USDJPY upside from here will likely be restricted by concerns on intervention. One thing that was more clear in the policy shift was the recognition by Governor Ueda that if Yen volatility and depreciation impacts the BOJ's outlook on inflation, it could lead to a policy tweak. To us, it indicates a higher chance of FX intervention, though still far from a broader shift to more overtly defending the currency. USDJPY downside, however, will likely need more certainty that a substantial compression in rate differentials is imminent to overcome the substantial negative carry being long JPY brings with it - and that will likely take some help from global yields. We see a flatter path for the USDJPY from here with a modest downside as US yields gradually peak over the next 3-6 months.
Have we seen the peak in yields?
That takes us to the other major policy decisions of the week. First, the Treasury’s Quarterly Refunding announcement showed less of an increase in Auction sizes than expected, total auctions for 3Y/10Y/30Y maturities this month came out to $112bn vs expectations for $114bn. The Treasury slowed the pace of longer maturity auction increases and guided towards just one more round of auction increases next year. While usually obscure, the last Refunding in early-August was potentially one catalyst for recent volatility in Treasury yields. Less of an increase on the long end could help soothe concerns that Treasury supply could cause yields to be disconnected from macro fundamentals.
Next up was the Fed. The Federal Open Market Committee (FOMC) kept its policy rate unchanged at 5.25-5.50% as expected with minimal changes to the policy statement. While no changes were made a few things stand out: the phrase “tighter financial conditions” was discussed in the statement as a headwind for households and businesses. That potentially reflects thinking that the recent rise in Treasury yields, equity market selloff, and stronger dollar could weigh on growth/inflation and substitute for further policy tightening. The other interesting element is that forward guidance was left unchanged and effectively keeps another hike on the table, but in the press conference Powell continually cited ways monetary policy was working through the economy and even went as far as to say the committee did not have a tightening bias.
All in all some good news for a change – the economy is softening (but not drastically), the Fed has maintained its “hawkish pause” and the U.S. Treasury surprised with less bond supply. The BOJ continues to surprise, and likely could again in the future, but for the moment policy appears suitable while growth remains healthy. Our bottom line remains the same, we think yields continue moving lower from here and growth and earnings will likely remain healthy enough to move equities higher in 2024.
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