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“I got that sunshine in my pocket”

Justin Timberlake, Can’t Stop The Feeling!

Over recent months we have discussed the interaction of growth and inflation risks across the globe as well as both the importance and inference of the respective Central Bank reaction functions. This week was the turn of the Bank of Japan who, amid a chorus of increasingly hawkish central banks globally, re-emphasised the primacy of its ‘persistent easing’ of monetary conditions through the asset purchase programme. While inflation has successively driven the monetary reaction functions of central banks around the world (starting in the emerging markets - notably Brazil - and working its way through the US and Europe towards Asia, but still only tentatively), the BoJ conceded that in the near term inflation risks are to the topside but that they are transient and due to external factors that ultimately mean the BoJ “does not see annual inflation hitting 2.0% by 2025”.

This has important connotations for financial markets. The knee-jerk reaction was to sell the JPY, as the BoJ double down on their QE purchases - unlimited amounts at daily auctions - in order to keep the 10y JGB yield within its target band (0.0% +/- 0.25%) thus fixing the JPY leg of a yield differential when (almost all) other countries are seeing long end rates higher pressured by persistent inflation pressures. Essentially, facilitating the prospect of further widening of the long end yield differential.

The BoJ maintains the narrative that “a weak currency is positive for the overall economy”, and this may be true on aggregate, but there is also an alternative viewpoint that has been expressed by German economist at the European Central Bank., who has been clear that at times when imported goods inflation is high, then countries should be careful about enabling a weaker currency as this is only likely to exaggerate the inflation from imported goods, thus further diminishing purchasing power and undermining the economic recovery. Of course, for the BoJ, while this may be beneficial to exporters, it also likely reduces margins of importers and may well suppress wages - the core target of BoJ and MoF to rid the economy of the (decades long) threat of deflation.

Looking ahead to next week, it is unlikely that the BoJ’s persistent, obdurate dovish stance will set a precedent. Next week sees significant rate meetings from the RBA, BoE and the Federal Open Market Committee (FOMC); all are expected to move towards a less dovish stance (even if none describe their actions as tightening). You could say that next week, from a G-10 monetary policy perspective, is a game of three halves!

First up is the RBA on Tuesday. At the start of the year, it was far from clear that the market expectations could be anywhere near fulfilled, after market positioning and pressure on the three year part of the curve buckled, and then broke the resolve of the RBA defending a yield of 0.10% (Oct 2021) and draconian Covid lockdowns persisted into 2022. However, the commodity price boom that was exacerbated by the energy concerns due to the Russia/Ukraine situation, changed the dynamic for Australia. The current account boost was laid bare this week, as the terms of trade date highlighted a 5% rise in import prices over the quarter and an impressive 18% rise in export prices for the same period. It is clear that the growth and inflation boost in Australia warrant a faster and bigger normalisation momentum than had previously been envisaged.

That said, markets are currently pricing in a 15bps rate hike for next week (after the higher than expected inflation print this week), half the usual increment. BUT it is not a clear-cut decision. Firstly, the RBA meeting comes ahead of the important official wage data (which is a quarterly measure) and while they will certainly have some other modelling or approximations, wage data has been held up as the dominant factor in the normalisation process and moving before it is released may hold some risks. Furthermore, while inflation was above target, the core measure for Q1 was only very modestly above the RBA target of 2-3%, the weighted median measure at just 3.2%. Finally, Australia holds its general election on the 21st of next month, and a rate hike so close could potentially be called political interference.

In the UK, the situation is also less than clear. Markets are debating a rate hike of 50bps (or a half of one percent) next week. However, amid what is constantly referred to in the UK media as the biggest cost of living crisis in decades, it is not clear that the BoE will hike 25bps, let alone the 50bps that many are calling for. It is true that the Bank have stated that underlying Bank Rate needs to be higher as a function of the structural supply changes post-brexit. It is also true that inflation is so high that inaction could suggest the Bank is neglecting the primacy and thus credibility of its inflation mandate. Equally, however, the MPC members will not wish to be retrospectively viewed as the dominant factor in snuffing out a recovery and driving the economy into recession. A tough job - indeed it is not beyond the realms of possibility that we see a three-way vote split with members voting for 0, 25bps and 50bps depending where they sit on the growth vs. inflation threat spectrum.

Lastly, and perhaps most predictably, we get the FOMC. USD rate curves have been very volatile of late, as markets battle with the implications of the Federal Reserve System(Fed’s) battle against inflation on the medium-term growth outlook. Prior to the blackout, the Chair of the Federal Reserve (and wider FOMC participant) message was very clear - the Fed intends to move in an expedited manner (50bps at least for the first couple of meetings) towards neutral (2.25-2.50%?). The Press conference will be closely watched, but as has been the Chair of the Feds style in recent months - preparing the markets ahead of time and then delivering just that (no more, no less), it seems likely next week follows the same path.

If we return to the currency implications alluded to earlier, then there are perhaps some important points for the medium term. We have mentioned on a number of occasions that we feel the Fed hawkish narrative is by default front loaded - with inflation so high it is important that the Fed are seen to ‘talk the talk’ in defense of the inflation mandate. However, it is not clear that as the second derivative of inflation turns negative, that the urgency of rate hike pressures will be so great. Furthermore, it is likely that there will be some impact through the currency channel that could damp inflation further in the second half of 2022.

In the rest of the world - notably Europe - the opposite is true. The currency devaluation (as warned by an executive board member of the European Central Bank.) is likely to have implications for domestic inflation and thus European monetary policy impulse may begin to strengthen, as that in the US falters. There are a number of other factors that potentially argue that we are coming towards the end of the USD bull cycle - factors for discussion another day.

In the near term, the risk backdrop keeps the USD on the front foot, but over coming weeks (starting with the global central bank narrative next week) we can envisage a scenario that is more positive than the current fearful market dynamic currently suggests.

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