The Fed sowed confusion with its new cautious stance

Outlook:

The Fed sowed confusion with its new cautious stance. Jobs are good and even inflation is trending in the correct direction, so the only thing to blame for caution is “global market conditions.” Numerous bond guys are quoted in the press as admitting they are confused about what the Fed is up to. One told the WSJ that the market will now be looking for the Fed to be behind the curve on inflation—thoroughly predictable!

Even though Yellen said the Fed is not considering negative rates, the idea of negative rates is a disruptive one. We hardly ever take note of what Norway is up to, and yet everyone reported the Norges Bank going negative and more than that, coming right out and saying “The current outlook for the Norwegian economy suggests that the key policy rate may be reduced further in the course of the year.”

The Norges Bank fully appreciates it is setting loose the hounds of war. "Lower interest rates could increase financial system vulnerabilities. As the key policy rate approaches a lower bound, the uncertainty surrounding the effects of monetary policy increases. This now suggests proceeding with greater caution in interest rate setting. Should the Norwegian economy be exposed to new major shocks, the Executive Board will, however, not exclude the possibility that the key policy rate may turn negative.”

Yikes! This is almost like the Norwegian central bank admitting it has caught the Japanese disease. And the Japanese experience is turning out to be a nightmare. The 10-year yield went to a record low -0.091% today. As the FT puts it, “Japan, like other major central banks, is discovering that negative interest rates are not the magic solution to inflation and a weaker currency but are instead bringing their own raft of unintended consequences.”

Everybody and his brother is wondering if the Japanese government will not try to engineer the yen lower—precisely when the market is giving it an upside breakout stronger. Yesterday the dollar/yen put in a breakout around 111.00 that set off stop-loss triggers and delivered a new dollar low of 110.67, something we haven’t seen since Oct 2014. Then we got a sharp, swift reversal by 100 points back to 112 on a story that the BoJ is “checking rates.”

Market News calmly reports “A decisive move towards Y110 or beyond would put the market on the alert for BOJ official jawboning, traders said.” The FT is a little more excitable. “Currency strategists at JPMorgan, who had previously forecast that the yen would strengthen to Y110 per greenback by the end of 2016, on Friday set a new target of Y103.” The BoA/ML strategist says the current moves are not yet extreme, but a rise to 100 would raise the probability of BoJ intervention to about 70%.

Japanese market players do not like negative rates. “On Friday, the 10-year JGB yield fell to a record minus 0.135 per cent after the BoJ’s operation to buy bonds with between 10 and 25 years — a process that was received with the lowest investor participation on record and prompted the yield on the 20-year note to fall 10 basis points to 0.29 per cent — a new record low and further evidence that NIRP is inducing a panic search for yield.

“The confusion provoked by NIRP has been especially damaging to the sentiment of foreign investors who have spent the majority of 2016 hardening their scepticism of Prime Minister Shinzo Abe’s attempts to boost the Japanese economy.

“In the week that ended on March 11, non-Japanese investors dumped a record Y1.58tn of stocks, adding to a year-to-date sell-off of Y5.87tn and a 10th straight week of net selling. Foreign equity investors ‘continue to treat the stock market as if it were toxic’, wrote Jonathan Allum, SMBC Nikko strategist, while others lament the fact that global fund managers continue to treat highly liquid Tokyo shares as the most ‘user-friendly ATM in the world’.”

Okay, maybe Japan is what the Fed is watching when it speaks of global market conditions—not China (whose premier Li said today China is absolutely determined to take any policy initiative necessary to keep growth on track). As an aside, Norway has sharply falling inflation expectations while Sweden reports rising expectations. Probably one of the biggest questions is whether the two big negative-rate central banks, the BoJ and the ECB, will go further. There has been some confusion on this point, with interpretations of the BoJ statement seeming to indicate no more but comments today implying it’s not off the table.

We have the same thing with the ECB. Draghi famously said he saw no need for additional negativity, but yesterday he opened the door a crack by saying rate may stay at current or lower levels for a long time. Lower? Today ECB chief economist Praet said rates have not reached their lower limit. He told an Italian newspaper "As other central banks have demonstrated, we have not reached the physical lower boundary.” According to Reuters, P:raet said if "negative shocks should worsen the outlook or if financing conditions should not adjust in the direction and to the extent that is necessary to boost the economy and inflation, a rate reduction remains in our armoury." He also agreed the ECB could deliver helicopter money to the public at large, although that would be extreme.

Yesterday we excoriated the Fed for being cowardly and naming unspecified global market conditions for pulling in its horns on the hiking schedule, but perhaps we were not given sufficient weight to the negative rate story. Norway apparently rattled a lot of people. The situation in Japan indicates the market did not take kindly to this form of government shepherding. So far the ECB is getting away with negative rates but that could be because the bank is offering hard money incentives to banks to increase lending in the form of the long-term repo facility--the carrot as well as the stick.

Bloomberg enjoys being provocative and has a story today reporting that some analysts think there is a secret Plaza-Accord type agreement that came out of the last G-20 meeting to stabilize markets and especially to drive the dollar down. Pimco chief economic advisor Fels says “There seems to be some kind of tacit Shanghai Accord in place. The agreement is to roughly stabilize the dollar versus the major currencies through appropriate monetary policy action, not through intervention.”

In agreement is Zervos of Jefferies, who believes the G-20 big shots believe a further major dollar rise against the euro and the yen would be bad for the global economy. “By acting to stabilize the dollar, the major central banks ease pressure on China to engineer a significant depreciation of its currency, a result that would be a disaster for the world economy, according to Fels and Zervos.”

This is all utter nonsense, of course. Former IMF chief economist Blanchard told Bloomberg "Maybe there was a meeting in a backroom in which they all agreed to do something. I don’t think so. The world looks a bit worse than it used to. Everybody is reassessing. I really don’t see any grand plan."

All the same, negative rates popping up in Norway after appearing in Japan and the eurozone could well be the single factor that the Fed was referring to when it named “global market conditions.” The Fed can’t come right out and blame Draghi and Kuroda (and Olsen) for staying its hand, can it? We expect the pullback to continue to aid the dollar early in the week, but watch out for mid-week, when the rout is likely to resume again—regardless of where yields go.