Down Under the RBA blinked
Regarding their policy linked
To Yield Curve Control
Which seemed, on the whole
To crumble and now is extinct
The question’s now how will the Fed
Address what’s become more widespread?
As prices keep rising
The market’s surmising
That rate hikes will soon go ahead
Here’s the thing, how is it that the Fed, and virtually every central bank in the developed world, have all been so incredibly wrong regarding inflation’s persistence while virtually every private economist (and markets) have been spot on regarding this issue? Are the economists at the Fed and the other central banks really bad at their jobs? Are the models they use that flawed? Or, perhaps, have the central banks been knowingly trying to mislead both markets and citizens as they recognize they have no good options left regarding policy?
It is a sad situation that my fervent desire is they are simply incompetent. Alas, I fear that central bank policy has evolved from trying to prevent excessive economic outcomes to trying to drive them. After all, how else could one describe the goal of maximum employment other than as an extreme? At any rate, as the saying goes, these chickens are finally coming home to roost. The latest central bank to concede that their previous forecasts were misguided and their policy settings inappropriate was the RBA which last night ended its 20-month efforts at yield curve control while explaining,
“Given that other market interest rates have moved in response to the increased likelihood of higher inflation and lower unemployment, the effectiveness of the yield target in holding down the general structure of interest rates in Australia has diminished.”
And that is how a central bank cries ‘uncle!’
Recall, the RBA targeted the April 2024 AGB to keep it at a yield of, first 0.25%, and then after more lockdowns and concerns over the impact on the economy, they lowered that level to 0.10%. Initially, it had success in that effort as after the announcement, the yield declined from 0.55% to 0.285% in the first days and hovered either side of 0.25% until they adjusted things lower. In fact, just this past September, the yield was right near 0.0%. But then, reality intervened and inflation data around the world started demonstrating its persistence. On October 25, the yield was 0.125%, still behaving as the RBA desired. By October 29, the end of last week, the yield had skyrocketed to 0.775%! In truth, last night’s RBA decision was made by the market, not by the RBA. This is key to remember, however much control you may believe central banks have, the market is still bigger and will force the central bank’s hand when necessary.
Which of course, brings us to the FOMC meeting that starts this morning and whose results will be announced tomorrow afternoon at 2:00pm. Has the market done enough to force the Fed’s hand into adjusting (read tightening) policy even faster than they have expressed? Will the Fed find themselves forced to raise rates immediately upon completing the taper or will they be able to wait an extended length of time before acting? The latter has been their claim all along. Thus far, bond traders and investors have driven yields in the front end higher by 25bps in the 2-year and 35bps in the 3-year over the past 6 weeks. Clearly, the belief is the Fed will be raising rates much sooner than had previously been considered.
The problem for the Fed is that the economic data is not showing the robust growth that they so fervently desire in order to raise interest rates. While inflation is burning, growth seems to be slowing. Raising rates into that environment could easily lead to even slower growth while having only a minimal impact on prices, the worst of all worlds for the Fed. If this is the outcome, it also seems likely that risk assets may suffer, especially given their extremely extended valuations. One must be very careful in managing portfolio risk into this situation as things could easily get out of hand quickly. As the RBA demonstrated last night, their control over interest rates was illusory and the Fed’s may well be the same.
With those cheery thoughts in our heads, a look at markets this morning shows that risk is generally being shed, which cannot be that surprising. In Asia, equity markets were all in the red (Nikkei -0.4%, Hang Seng -0.2%, Shanghai -1.1%) as the euphoria over the LDP election in Japan was short-lived and the market took fright at the closure of 18 schools in China over the increased spread of Covid. In Europe, equity markets are mixed with the DAX (+0.5%) and CAC (+0.4%) both firmer on confirmation of solid PMI Manufacturing data, but the FTSE 100 (-0.5%) is suffering a bit as investors grow concerned the BOE will actually raise the base rate tomorrow.
Speaking of interest rates, given the risk-off tendencies seen today, it should be no surprise that bond yields are lower. While Treasury yields are unchanged as traders await the FOMC, in Europe, yields are tumbling. Bunds (-3.5bps) and OATs (-5.6bps) may be the largest markets but Italian BTPs (-10.7bps) are the biggest mover as investors seem to believe that the ECB will remain as dovish as possible after last week’s ECB confab. Only Gilts (-0.4bps) are not joining the party, but then the BOE seems set to crash it with a rate hike, so there is no surprise there.
Once again, commodity prices are mixed this morning, with strong gains in the agricultural space (wheat >$8.00/bushel for the first time since 2008) and NatGas also firmer (+3.0%), but oil (-0.35%). Gold (-0.1%), copper (-0.5%) and the rest of the base metals softer. In other words, there is no theme here.
Finally, the dollar is having a pretty good day, at least in the G10 as risk-off is the attitude. AUD (-0.85%) is the worst performing currency as positions get unwound after the RBA’s actions last night. This has dragged kiwi (-0.7%) down with it. But NOK (-0.6%) on lower oil prices and CAD (-0.3%) on the same are also under pressure. In fact, only JPY (+0.35%) has managed to rally as a traditional haven asset. In emerging markets, the outlier was THB (+0.6%) which has rallied on a sharp decline in Covid cases leading to equity inflows, while the other currency gainers have all seen only marginal strength. On the downside, RUB (-0.5%) is feeling the oil heat while ZAR (-0.2%) and MXN (-0.2%) both suffer from the metals’ markets malaise.
There is absolutely no data today, nor Fed speakers as all eyes now turn toward ADP Employment tomorrow morning and the FOMC statement and following press conference tomorrow afternoon. At this point, my sense remains that the market perception is the Fed will be the most hawkish of all central banks in the transition from QE infinity to the end of QE. That should generally help support the dollar for now. however, over time, the evolution of inflation and policy remains less clear, and if, as I suspect, the Fed decides that higher inflation is better than weakening growth, the dollar could well come under much greater pressure. I just don’t think that is on the cards for at least another six months.
Good luck and stay safe