Chief Investment Strategist
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Yesterday’s key monetary policy announcements – the Fed’s inaction and the Bank of Japan’s inaction – both reflect the international pressures to avoid “policy divergence.”
This principal has been guiding central banks since at least the February G-20 meeting. It also creates complexities in the outlook for world markets this year.
Virtually no one expected the Fed to raise short-term interest rates yesterday. The immediate reaction in markets was therefore benign. Assuming this should be a goal, the Fed successfully guided expectations by previously noting that an April tightening would make it seem the need for action was “urgent.”
The Fed’s case for pause will be helped by today’s first quarter U.S. GDP data, which showed a mere 0.5% gain. However, this is little different from the 0.75% average seen in the current expansion-to-date for first quarter periods (see figure 1). Subsequent 2Q periods have averaged nearly 2 percentage points stronger than 1Q. The recurring, soft-1Q output pattern reveals a new seasonal bias since the introduction of additional data sources around 2010.
In contrast to the slow 1Q U.S. GDP, the 209,000 average gain for monthly employment last quarter exceeded the 165,000 average for the previous six years. Labor markets have gradually accelerated relative to GDP with a lag. A large labor strike will weaken April’s U.S. job headlines despite a 43-year low in new jobless claims this month (see figure 2).
If current U.S. interest rates are somehow mismatched to long-run growth and stability goals, last year’s U.S. dollar strength, binary political challenges (i.e. the U.K.’s June 23 referendum) and mere expediency should keep the Fed on hold for much of 2016.
Japan’s inaction, in contrast, came as a big surprise. As a consequence, the yen strengthened a dramatic 2.7% today, a 4.1 standard deviation event. Japanese equities plunged 3.6%.
Citi Japan economists expected no action today as Japan will host a G-7 meeting in May. As we’ve been documenting, the international pressure on Japan to avoid exchange rate spillovers has intensified. However, if the idea is to avoid “disorderly” foreign exchange fluctuations, the BOJ’s communications and coordination with other central banks is not achieving it. Given that the European Central Bank unveiled steps last month to offset the negative impact of a negative deposit rate on its banks, we believed simply matching the ECB’s steps would hardly represent a break from the currency war “cease fire.”
The BOJ is far from sidelined. Japan’s existing QE program is expanding the central bank’s balance sheet at an annualized clip that’s equal to 20% of GDP. In 2017, the BOJ’s balance sheet will roughly match the size of the Fed’s with an economy that is one fourth the size (see figure 3). We’ve always believed it takes a mountain of asset purchases to move forward by inches in real economic activity as the situation in Japan has not broken away so completely from the so-called liquidity trap of recent decades. Yet it’s very difficult to imagine that this persistent asset accumulation – with no end date - is completely without consequence. Given the negative average interest rate on Japan’s sovereign debt, Japan’s costs of a debt-financed fiscal expansion are surreally negative as well.
The ECB shocked markets with inaction in October 2015, and subsequently did much more in March 2016 than it ever anticipated doing when it disappointed. While there are legitimate concerns of “monetary policy fatigue,” Japan has already taken steps other developed market central banks have not, including accumulating equities with newly created reserves, Japan owes massive debts to itself and it’s difficult to see the rest of the world valuing paper yen as an ever-appreciating real asset.
More practically, Japan’s need to counter a building economic headwind from the yen’s appreciation will become clearer after today’s market shock (see figure 4). Since early April, markets were greeted with a daily flow of commentaries from officials from the BOJ, Ministry of Finance and the cabinet office suggesting that a stimulus package was coming. As PM Abe stated that he intends to adhere to the February G20 agreement to avoid currency war, the announcement may need to wait for the G7 summit to be held in Tokyo on May 26-27. It is difficult for the BOJ to announce the monetary policy part of this package on its own ahead of the national package. If so, market's enthusiasm for action today was not incorrect, just too early.
Notably though, Japan’s need for stimulus itself, troubling long-term demographics, and a large petroleum deficit in a time of rebounding oil are vulnerabilities that weigh against a long-term optimistic view. Citi Private Bank’s overweight to Japan equities has been cut from a high of +6.0% in early 2011 to the current +0.2%. If policydivergence reasserts as we expect, and Japanese policymakers follow a path of reactionary easing akin to the ECB, we would consider further paring our weighting. Our position on negative-yield Japanese bonds remains deeply underweight and should remain so regardless of any appreciation.
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