One of the most challenging issues for market observers over the past year has been the deciphering of communication from central banks around the world, as the inconsistent messaging has created headaches for participants, resulting in wild swings in asset prices as investors try to position portfolios in accordance with the erratic guidance. To be fair, the unprecedented amounts of liquidity injected into the financial system in the wake of the financial crisis in 2008 have made the economic landscape challenging to navigate for central banks, and as such, the policy tool-kits administered by the aforementioned central banks continues to evolve in response to the changing economic climate. The Federal Reserve has not been immune to the communication challenges faced by global central banks, which has resulted in its credibility being challenged by market participants as their forecasting abilities have turned out to be sub-par at best. This was evident in events leading up to Janet Yellen’s speech in Jackson Hole, with the US dollar paring recent gains as participants had little faith Yellen would echo the latest comments of her colleagues, and her speech would shape a further deviation from recent economic projections, specifically in regards to the short-term interest rate trajectory.
The initial market reaction to what we considered as a relatively hawkish speech for Yellen was one consistent with the Fed’s recent loss of credibility, as participants looked past the piece in the statement where Yellen opined the case for continued normalization of monetary policy had strengthened in recent months, and instead focused on some of the longer-term dovish implications of additional policy tools should the real neutral interest rate remain close to zero if the slow productivity growth and high global saving rates continue. It wasn’t until later in the trading day when Vice Chairman of the Fed, Stanley Fischer, hammered home that Yellen’s statement was still consistent with a possible rate hike in September and that nothing Yellen said ruled out the potential for two upward moves in interest rates this year, that market participants reassessed their initial reaction to Yellen’s speech, and swung the pendulum back in favour of a steeper interest rate trajectory. As a result, the DXY whipsawed to recoup its earlier losses and finished at its highest level over the last two weeks, breaking outside of the relatively narrow range it had been contained within as summer liquidity conditions dampened volume. The VIX finally managed to show some life as volatility found its way back into the market, resulting in downward pressure on the S&P into the end of the week.
While we had previously opined that should Yellen confirm the earlier views of both Dudley and Fischer, this would strengthen the case for a rate hike by the end of the year, and thus underpin the American buck’s performance, a lot will still depend on the upcoming economic data points, especially this week’s August employment report. It would appear that given the recent communication from the Fed, the board members are focusing less on the variability of their long-term forecasts, and putting more stock on the short-run economic factors they can influence directly. We have mentioned this point previously, but paramount in the assessment of the economic landscape is aligning interest rate policy with what would be considered normal business cycles, and as such, the Fed is likely to want to try and continue to normalize rates in order to allow for future policy flexibility further down the road. Another strong employment report at the end of this week would help the greenback build on its recent gains, as the cohesive signals from the troika of Fed leadership will likely put the market back on more balanced footing and not the asymmetric downside risks participants were biased towards before the Jackson Hole symposium. Though interest rate futures are signalling approximately a 33% chance the Fed moves rates higher in September (from 21% prior to Jackson Hole), we would suggest this has the potential to get closer to even-money should Friday’s job report show further signs of tightening in the labour market. The current status of the presidential race and Clinton’s lead over Trump in the polls (albeit down from its peak last week) helps the case to forego any further delays in monetary policy normalization, though the big takeaway from the Brexit referendum was that “it’s not over until it’s over”, and a surprise result cannot be ruled out until the final vote is counted. That being said, if there is another strong employment report that hits the wires at the end of next week, the Fed might not want to miss the chance of hiking rates, for fear something down the road could potentially derail their forecasted trajectory yet again.
While a great deal of market focus has been on the signals from Federal Reserve leadership in determining the short-term roadmap for monetary policy, the Saturday sessions gave rise to increased discussion on what it may take to shift the expectations of businesses and households in developed countries, brightening the outlook in order to stimulate the global inflationary picture. A prime example of this issue is in Japan, where household expectations for future inflation have been stubbornly low, with Bank of Japan Governor Kuroda admitting that long-term inflation expectations may not yet be anchored. The Eurozone faces a similar problem, and while there has been some initial success with interest rates below the zero-bound, inflation expectations have not changed dramatically, creating a disincentive for governments to undergo structural reform. Gaining traction is the economic viewpoint that with monetary policy operating at full throttle and the incremental benefits of further expansionary policy being negligible, the baton will need to be passed from central banks to governments. Specifically, Princeton University’s economist suggested ineffective monetary policy can be replaced by fiscal expansion, if those deficits are “aimed at, and conditioned on, generating inflation.”
We had previously discussed Canada’s small deficit financing from the new Liberal Government has likely being sufficient in the short-term to stave off further rate cuts from the Bank of Canada, and the first of the developed countries to move away from monetary policy accommodative to fiscal expansion (albeit by very small standards.) The most likely area where we could see this first occur would be in Japan where the notion of “Helicopter Money” has already been discussed, and maybe Abe and Kuroda’s only hope at shocking the public’s views on long-term inflation. In effect, the application of “Helicopter Money” would remove the banking sector as an intermediary, and essentially facilitate deficit spending via printing money. Though outside the scope of this piece to delve into the nuances of such a program to be implemented by countries struggling with disinflationary pressures, the potential for this school of thought to gain traction will have vast implications for market participants and portfolio construction, and thus will be keen to keep an eye on in the future.
Good luck out there!
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