Central Bank fest

In terms of central bank meetings, the week ahead is one of the busiest.  No fewer than 13 central banks hold policy meetings, divided between six major and seven emerging markets.  While the significance of US monetary policy for the world makes the FOMC meeting a highlight, it is Norges Bank, Norway's central bank, that will steal the march, becoming the first high-income country to lift rates since the pandemic struck.  

Among the emerging market central banks, Brazil is poised to hike the Selic rate by another 100 bp, as it did in August after three 75 bp moves.  Hungary is also expected to continue its tightening cycle. In contrast, the President of Turkey's central bank shifted the focus to the core inflation rate, which opened a door that appeared closed for a rate cut as early as its September 23 meeting.  The other four emerging market central banks that meet (South Africa, Taiwan, Indonesia, and the Philippines) are widely expected to stand pat.  

Norway's central bank did the right thing.  It slashed its overnight rate from 1.50% to zero when the pandemic struck.  Although voted out of office after two terms, the government got high marks for handling the virus.  The economy was cushioned by the petroleum fund but is not overheating by any stretch.  The latest read put the June unemployment rate at 4.8%, almost a percentage point above the end of 2019 level.  After contracting in Q1, the economy snapped back in Q2 and remains firm into Q3.  Headline inflation is elevated at 3.4% in August. It has not been above 3.5% since 2016.  However, the underlying rate, which adjusts for tax changes and excludes energy, fell to 1% in August, a four-year low.  It seems the Norges Bank will raise rates because keeping the deposit at zero as the economy recovers is not prudent.  

There is not much the Bank of England can do.  Last month, there was one dissent in favor of a minor slowing of Gilt purchases, but he unlikely managed to persuade his colleagues.  The furlough program ends later this month, and by the time the next meeting comes around (November 4), some greater insight into the state of the labor market will be available.  Governor Bailey revealed that the eight MPC officials were split evenly on whether the minimum conditions for a rate hike exist in August.  The new chief economist will vote next week, and he is seen, like his predecessor, as a hawk.  Mann replaces Vlieghe, and both of whom are perceived to be dovish in the current context.

Still, a 5-4 majority believe that a hike's minimum condition has been met but it does not mean a rate hike is imminent.  Bailey himself drew a distinction between the minimum and the necessary conditions.  The latter have not been met.  Still, the first hike looks nearly discounted for around the middle of next year, and after the stronger than expected rise in August CPI (nine-year high), the market appears to be pricing in more than one rate hike next year. The first hike may be 15 bp to unwind the last cut (March 2020) before resuming the more traditional quarter-point moves.  

While the Bank of England will likely be in the first wave of high-income central banks to raise interest rates, the Bank of Japan is understood to be a laggard.  Although Japanese growth was stronger than expected (Q2), deflationary forces tightened their grip.  The GDP deflator was -1.1%, the most in a decade.  Some board members may want to do more, but Governor Kuroda, whose term extends to April 2023, does not seem to be so inclined. 

The Liberal Democratic Party of Japan holds its leadership contest on September 29, and it will, in effect, be choosing the next prime minister. The lower chamber of the Diet's session ends on October 21, and an election is expected to be held around then. The LDP is reportedly preparing for a large supplemental budget (~JPY30 trillion).  Maybe some contours of it will be shaped by the new prime minister.  The vaccine and administrative reform minister Kono appears to be the favored candidate, and he, for example, has talked about building a sustainable infrastructure that is resistant to natural disasters.  

Sweden's Riksbank is going to be a laggard in this cycle too.  It is more comfortable than the Norges Bank in keeping its key rate at zero.  The economy is recovering well.  The composite PMI has been above 60 every month this year.  The economy expanded by 0.9% in Q2 after a quarterly expansion of 0.8% in Q1.  It will be one of the stronger economies in Europe this year. August inflation, reported last week, was stronger than expected.  The headline stands at 2.1%, up from 1.4% in July, but the Riksbank pays more attention to the measure that uses a fixed interest rate for mortgages.  That accelerated to 2.4% from 1.7%.  The underlying rate, excluding energy, nearly tripled from 0.5% to 1.4%.  The base effect is playing a role here, pointing to upside risks in September through November reports.

This year, the Swedish krona is among the weakest currencies, posting a 5.25% loss through the end of last week.  Only the Australian dollar (~-5.4%) and Japanese yen (~-6.1%) are off more among the majors. After underperforming last year (~6%), Sweden's OMX 30 Index is among the best this year, up nearly a quarter.  Sweden's 10-year yield has risen about 20 bp this year to 0.22%.  

The Swiss National Bank meets on September 22. It, too, will be lagging in the next monetary cycle. Unlike Japan, however, it slayed the deflation dragon.  At 0.8%, the EU harmonized measure of inflation is the highest since April 2019.  However, the OECD's measure of purchasing power parity puts the Swiss franc as the most over-valued currency (~18.2%).  Last week, the Swiss franc was the weakest of the major currencies, falling almost 1.6% against the dollar, putting it at five-month lows.  The euro is trading above its 200-day moving average against the franc (~CHF1.0900) for the first time in two months.  

That brings us back to the Federal Reserve. In our understanding, the market has been anticipating this meeting since the spring to provide further guidance that the Fed will reduce the pace of bond purchases.  Chair Powell promised that to minimize the chances of a 2013-esque "taper tantrum," ample notice to investors will be given.  We have argued that the acknowledgment in the July FOMC minutes that a majority favor tapering this year does not reach the threshold of ample notice.  Nor did the fact that Powell repeated it in Jackson Hole.  

While it seemed reasonable to expect the tapering prospects will be mentioned in the FOMC statement, it does not need to lock in a specific start.  Instead, we suspect that the Fed may want to confirm the beginning of the process at a meeting, which seems to reduce the chances that tapering will begin as early as next month.  At the same time, it does not materially matter to most market segments if the tapering starts in November or December.  

When the tapering process is over it may be more important than when it begins. Powell has been clear that tapering is not tightening and that the criteria for a rate hike are different than the threshold to start tapering.  Nevertheless, barring a new and significant negative shock, the Fed will raise rates sometime after tapering is completed.  The market continues to price in a hike before the end of 2022.  

Here is the math behind this observation.  The Fed funds futures contract settles at the effective average of Fed funds over the course of the month.  This is different than the target rate.  Recall that the average rate was threatening to drift toward zero, which dragged down other money market rates. In June, the Fed responded by tweaking (technical adjustment) the interest on deposits at the Fed and the rate on reverse repo operations.  This lifted the average effective Fed funds rate to 9-10 bp.  However, it has been drifting lower again and steadied around eight basis points since late last month.  

Assume for the sake of the argument that in the first 14 days of December 2022 that the Fed funds effective rate is still eight basis points.  The FOMC hikes by 25 bp at the conclusion of the meeting at the end of next year, which lifts the effective rate to 33 bp, then ((14 days at 8 bp) + (17 days x 33 bp)/31).  That would produce an average effective rate of almost 22 bp.   The contract settled last week with an implied yield of 24 bp.

Recall that in the June projections, two Fed officials thought two hikes in 2022 would be appropriate.  So in our scenario of the Fed finishing its tapering around mid-year, we should also monitor the September 2022 Fed funds futures contract.  Next September's meeting concludes on the 21st.  Again, assume the Fed funds averages eight basis points through the Fed meeting and then 33 bp afterward ((21 x 8) + (9 x 33)/30).  A hike fully discounted in the September contract implies a yield of 15.5 bp.  The contract settled last week at 13.0 bp.  

Ironically, the Fed's assessment of the economy sketched in the first part of the FOMC statement may recognize, as the Beige Book did, that activity eased a bit in recent weeks.  Economists have also been caught leaning the wrong way, which is reflected in the data surprise indices.  Indeed, weaker than expected August jobs growth made some participants have second or third thoughts about Fed tapering.  Then the slower pace of consumer inflation offered further encouragement that the Fed could "delay" tapering. The surprisingly strong retail sales report (key signal was the strongest in five months) and Philadelphia Fed manufacturing survey (matching a four-month high) should put to rest such talk.  

Given that nearly everyone and their sister recognize the likelihood that the Fed provides a clearer signal of its intention to reduce the pace of its bond-buying before the end of the year, the dot plot is another communication channel that could spur a market reaction.  The summary of economic projections (dot plot) was launched in 2012, and Fed Chairs have consistently tried explaining the limitations of the exercise. Nevertheless, many market participants take the median view to represent "the Fed view."    

The reaction function of the market may be driven by two components.  The first are the forecasts for the Fed funds rate itself.  In June, seven officials thought a hike next year would be appropriate, and, as we have noted, two thought two hikes would be needed.  We think that the risk is that a couple of more officials now see a 2022 hike.  The second dot of particular interest is the one for inflation forecasts.  And remember, the Fed targets the headline PCE deflator (what it means to call the core rate the "preferred" measure escapes me).  In June, the median forecast put this year's inflation at 3.4% before falling to 2.1% next year and 2.2% in 2023. It stood at 4.2% in July.  This year's inflation forecast then will likely be revised higher, and the reversion to the mean may be seen taking somewhat longer.  The Fed has not specified the period the "average" of the "average rate of inflation" refers to, but we note that 3-year and 5-year averages converge at 1.80%.  

The Dollar Index bottomed, and the Bannockburn World Currency Index (GDP-weighted) topped with the weak August jobs report on September 3.  Arguably the market has been pricing in a hawkish outcome to the FOMC meeting.  Could the meeting mark a near-term dollar top?