After disbelieving the Fed for months, markets braced for a powerful message accompanying the first rate hike of this year. But that didn’t happen. One dovish hike and speech made markets question the determination of the Fed once again, resulting in falling interest rates.
Each quarter, Fed-members deliver their estimates for the appropriate policy rate in the coming years. Together these estimates make up the ‘dot plot’, from which the number of (implied) Fed hikes can be derived. For this year that number is three. Taking into account the fact that the Fed has raised rates only three times during the last de decade, three rate hikes this year is pretty impressive. However, it’s also no different from the December dot plot. Despite all the upbeat macro numbers is recent months, the Fed-members left their dots unchanged. This includes St. Louis Fed president James Bullard, who got cold feet halfway through last year and has delivered extremely low rate forecasts ever since.
Hence, bond markets ‘reidentified’ themselves with the familiar adage of ‘lower for longer’. But does this still make sense? Over the last couple of months circumstances have improved. The US economy is at, or at least close to, full employment, suggesting wages should start to grow faster from here. Inflation (headline 2.7% and core 2.2%) is at levels we didn’t consider alarming before. Certainly these inflation levels didn’t require a Fed target rate of just 1.0%. In addition, the chance of a recession is low, and confidence in the economy looks robust. Not if you are Mr. Bullard, obviously.
8 – 1
Markets seem to assume that, apart from the Fed, central banks don’t dare think about monetary tightening. But this assumption is likely false. Last week the Bank of England left interest rates unchanged. And while this was fully anticipated, the fact that one of the nine voting members opted for a hike was not. Also, other voting members suggested they were also considering such a move. This is not at odds with market expectations that policy rates will not go up for another two years. This discrepancy deems large.
What about the ECB? The central bank won’t move for some time, but the odds of QE tapering have increased significantly in recent months. To prevent scaring markets the ECB will have to ‘pre-announce’ such a move well in advance. With the economy and inflation improving, Draghi will be forced to start looking for the exit. The current level of bond yields tells me this is not fully incorporated in market prices yet.
This leaves Japan. If there’s one central bank that can build a case for quantitative easing it has to be the Bank of Japan. After a massive depreciation of the yen in recent years, inflation has failed to pick up. But was this any different before the financial crisis, when nobody had ever heard of QE? Still, the Bank of Japan will continue buying Japanese debt (and equities) for some time to come. It owns ‘just’ 39% of all outstanding debt, so there’s certainly room for more.
The big picture
With all the quantitative easing that has been going on in recent years it’s not difficult to lose sight of the bigger picture. Hence, the table below. It shows the current levels of headline and core inflation and a measure for long-term inflation expectations. ‘Red’ means doesn’t require QE, ‘green’ means it could require QE.
In the US and the UK, the need for an extremely accommodative policy stance is very limited. Even inflation expectations, considered as the holy grail of inflation measures by many central bankers, look decent. In the Eurozone core inflation is obviously too low, and with a little imagination inflation expectations could be just a tiny bit higher (say 1.8%/1.9%). But even then the amount of QE deployed by the ECB is at least debatable. Finally, everything is ‘green’ in Japan, but this comes with a giant disclaimer stating that inflation is no worse than before the financial crisis. In fact, inflation was negative basically all of the time between 1998 and 2008. Therefore, I cautiously conclude that the table above would probably not have led to so much stimulus before 2008. We’ll have another dot plot in June.