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“Who needs action when you got words?“

Nirvana, Plateau

Last week we discussed our growing conviction that the Fed (and by extension a number of other DM Central Banks) are closer to the end of their hiking cycles than current market expectations and indeed, current market pricing - highlighting the rising prospect that the Fed hike 25 in Feb and pause in March (25 and done) - a prospect that has again likely increased in probability this week.

Over recent weeks we have also described our views on the prospects for a non-linear demand progression (as a function of the negative wealth and sentiment effects of falling house prices, and indeed the non-linear implications of the end of the effects of covid stimulus payments - at the consumer and local government level on future consumption). In essence, a sharper weakening of consumer activity than expected. Over recent days, weeks we have seen lower average hourly earnings, a very weak services ISM reading (a collapse in new orders), a weak Empire manufacturing activity number, lower PPI (as well as CPI), weaker retail sales data (and downward back revisions to retail sales and industrial production) and much higher credit provisions from US banks in the Q4 earnings data - all supporting this thesis.

For once, however, it was not the US or the Fed that took centre stage in terms of the events of the week, but the Bank of Japan (BoJ), and the Japanese yen (JPY).

After the surprise move in December, where the BoJ widened the Yield Curve Control (YCC) band - A process that Governor Kuroda described as relating to the functioning of financial markets and did not constitute a tightening of monetary policy - markets have been keen to price the next stage of BoJ monetary normalisation. This week they were disappointed. At least briefly. We have some thoughts.

Expectations were high, going into the announcement, that there would be a new adjustment, or even abandonment of the YCC upper band (0.50%). After all, if the BoJ adjusted the YCC limit in December due to disorderly market functioning, or a market trading persistently above the band, then the fact that 10y JGB yields had traded above the higher band for days ahead of the meeting suggested perhaps that market functioning had not returned.

The reality was that the BoJ (Kuroda) left the policy rate, YCC target and the commitment to add further easing if needed, all unchanged. "The Bank will continue with large-scale JGB purchases and make nimble responses for each maturity by increasing the amount of JGB purchases and conducting fixed-rate purchase operations."

The BoJ not only countered expectations of a policy tightening, but via a technical adjustment to the funding supply operation (making it applicable beyond 2 years - up to 10 years at any rate deemed appropriate for market conditions at the time - to be tested in practice at the 5y part of the curve next week). Effectively a new tool from the BoJ to exert greater control over the curve and counter some of the upward pressure on term yields. Essentially the BoJ have the ability to set the swap rate lower and thus facilitate an arbitrage (encouraging the market to buy the bonds and cap the yield) if the yield gets high enough.

Thus, it could be argued that this week’s BoJ was a net easing not tightening, alongside a new tool to battle the distortion / market functioning of the curve - giving the BoJ the ability to set the swap lower than the YCC band limit and thus encourage buyers of bonds to close the arbitrage. Kuroda won the battle of the wills, for now.

Markets have now raised the vol premium for the next two BoJ meetings (March under Kuroda and April under his successor) and as they continue to anticipate a normalisation before the end of the Kuroda term as Bank of Japan governor (end of Kuroda and leaving more of a clean sheet for his successor), or an immediate policy shift from the new incumbent. However, the next meeting (10th March, Kuroda’s last) is also the end of the fiscal year and rate / curve / liquidity distortion at this time could have more contagious implications. Exit from YCC therefore may well be the first move of the new Governor!

The BoJ also raised the inflation and cut the growth projections for the forecast horizon - most notable in this regard was Kuroda’s reference to accelerating wage inflation (the key battleground for a sustained escape from deflation and thus monetary activism in Japan). However, our view remains that while it is entirely possible that the new BoJ governor may wish to take a different, less activist stance towards inflation / deflation, we are less convinced that the new BoJ will believe that the inflation fight has been won and the risks of relapse are minimal - especially when global disinflation appears to be taking hold. This does not mean that JPY cannot appreciate significantly further from here. There are a number of other global macro factors driving the current JPY dynamic - beyond the near-term focus on the life expectancy of YCC.

Even with the JGB curve relatively fixed, the narrowing differential relative to the US continues amid markets increasingly questioning the ability of the Fed a) to raise rates to the levels suggested by the December dots and b) to be able to keep them in restrictive territory for any significant period with the economy, labour market and inflation cooling as we have discussed. Thus, USDJPY maintains a US rates beta.

Furthermore, with the huge external balance of Japan (a negative NIIP - net international investment position - of close to three trillion dollars, perhaps two thirds denominated in USD assets) against the current backdrop likely provides JPY with significant potential (if not kinetic) energy. Japan has been a net seller of UST for a number of months now - a theme that likely continues as spreads narrow and global uncertainties remain. In addition to this, going forward, while selling US equities at current levels may not be attractive, hedging the USD exposure as spreads narrow likely is.

From a macroeconomic perspective we have been clear that bonds and duration likely outperform against the current backdrop as inflation moves lower, terminal rates (and eventual rate cuts) move closer and growth risks rise, in some respects you could also describe JPY as the ‘Bonds’ of the currency world. It likely benefits in a world where US rates peak relative to Japan or in a world where growth concerns begin to drive more risk aversion - through the channel of higher USDJPY / risk asset correlation and thus higher domestic FX hedging ratios.

Over coming weeks, we expect the market pricing of ‘soft landing’ in the US to be questioned to a greater degree. Pre-announced layoffs from big tech and consumer focussed industry will increasingly take effect in January (visible in the January US employment report) and thus a further cooling of the labour market will ease Fed concerns about more persistent wage pressures, second round effects, de-anchoring of inflation expectations and thus by default their core inflation focus ‘non-housing related services’ can ease faster than anticipated. When the facts change, so will the monetary policy bias of the Fed. Until now, the Fed bias on inflation has been that the risk of doing too little is greater than the risk of doing too much. Weaker growth and an adjustment to the Fed’s central scenario of a soft landing likely changes all that.

Recent weeks have emphasised the importance of words and not just actions from a central bank perspective reflecting the Nirvana lyrics “Who needs action when you got words”. While the BoJ are increasingly reliant on their words, the FOMC may be approaching the end of their actions. Interesting times for central bankers and the financial markets!

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