We have talked about central bank policies extensively in recent years, and let’s face it, it’s a really dry subject. Unfortunately for us, Central Banks remain very important actors in the financial markets, and subtle changes can have both visible and hidden effects. Perhaps the most obvious changes are being seen at the US Federal Reserve, but we also detect more subtle changes in Europe and Japan. Spotting these changes is the easy part. Understanding what impact they have on market prices, both short and long term, is the hard part. With that caveat, let’s have a look at what’s happening.
First to Japan. In the immediate aftermath of the move to both QQE and Yield Curve Control (YCC) last year, we said that these policies goals were simply not achievable at the same time (SEE SEPT 2016 REPORT). The BoJ would simply not be able to expand its balance sheet by 80 trillion Yen a year and control yields out to 10 years (a target of zero was established at the time). What was not clear was whether in the pursuit of yield curve control, the BoJ would print more or less than 80 trillion per annum.
The first test of the yield curve control policy came in February when 10 year yields nudged above 0.10%. The BoJ promptly stepped in with increased bond purchases, and yields subsequently moved back towards zero. Since that increased intervention, BoJ bond purchases have slowed, as can be seen in the chart below (courtesy of MI2 Partners). Indeed, if BoJ operations continue at the current pace for the rest of May, purchases will fall below 8 trillion for the first time since October 2014.
Chart 1 – Bank of Japan bond purchases
So, is the Bank of Japan tapering? Testifying in front of the Lower House Finance Committee on Wednesday, BoJ Governor Kuroda said the BoJ’s JGB portfolio is increasing “…at a pace of about ¥60 trillion annually.” Kuroda continued, “…we have not set a target of increasing monetary base by ¥80 trillion annually as we did before.” Although there has been no official change in policy, it certainly seems like the BoJ is tapering its bond purchases, as evidenced by both their buying of bonds and what the Governor is saying.
In Europe, we know that the ECB has reduced its bond purchases by €20 billion as of April this year, down to €60 billion per month. Furthermore, they have pre-committed to maintain this pace of until the end of the year. The market is very keen to hear from Draghi what his next move will be and when. There have been stories floating around that he may announce something next month. Personally, we think he will wait until September. Either way, the main point is that, with the European economy performing quite nicely at the moment, and core inflation trending back towards the “close to but below” 2% target, further tapering will be announced within the next four months or so.
The craziest central banks in the World today are the junior European banks, specifically the Swiss National Bank (SNB) followed by the Riksbank. Looking at the SNB, it is clear that they have a standing order to intervene in the FX market to weaken the Franc. Chart 2 below shows the SNB Reserves (accumulated via balance sheet expansion) alongside the EUR/CHF exchange rate (which is inverted).
Chart 2 – SNB Reserves and the EUR/CHF exchange rate
In the wake of the Macron win in the French Presidential elections, risks to the European project have been evaporating, at least in terms of financial market risks. This has led to quite a marked outperformance of the Euro versus the Swiss Franc, and we suspect that this will allow the SNB to take its foot off the accelerator and reduce its intervention quite significantly.
And so onto the US. We’ve remarked before how the Fed appears to have a different attitude from last year. Simply put, they appear to be very comfortable with two more rate rises this year, and there is widespread talk that they may start reducing their balance sheet before year end, with one or two calling for this to happen sooner rather than later. There are also one or two FOMC members who seem to want more than two more rate rises this year. All told, the Fed is beginning to look modestly hawkish for the first time since before the financial crisis.
For good measure, we will also note that the Peoples Bank of China (PBoC) is no longer increasing its balance sheet, which is at roughly the same level as two years ago (chart 3 below), and interest rates along the entire curve have been rising since late last year as Beijing tries to cool down a rampant credit machine.
Chart 3 – The PBoC balance sheet with 12 month rate of change
We have all major central banks changing policy at about the same time. Central Banks in Europe and Japan are simply easing off the accelerator, whereas in the US and China, there is a hint of hawkishness not seen for a long time. These are at least subtle changes taking place which we believe could be incredibly important during the second half of this year.
We have noted several times recently how the Fed, once it starts tightening monetary policy, usually continues until something breaks. Considering the lethargic performance of the US economy, this new found (but still modest) hawkishness is very interesting. Stepping back, although the ECB and BoJ will want to move with tiny baby steps, we also think that behind closed doors, there is a growing sense in policy making circles that negative interest rates may not be such a good idea. If true, we may see benchmark yields move back to zero during this tightening phase, unless/or markets have a tantrum.
Perhaps the trickiest balancing act is in China. The increase in debt in recent years, and the associated bad debts, are simply staggering. The boom/bust cycle that Beijing perpetuates in order to avoid financial crises is only storing up trouble for later. We don’t know when that trouble will arrive but we suspect it will probably not happen until after the party congress in October.
What does this mean for markets? We propose to flesh this out in detail in the next few weeks, but simply put, we believe that risk assets such as equities and lower quality bonds are vulnerable to losses in the near future. This is not a prediction that these markets will go down immediately as trying to time such a move has been impossible in recent months. However, we can point to the low levels of volatility everywhere, the very narrow participation in the US stock market as well as the anecdotal evidence we have noted in our last two bulletins as strong warning signs.
For our part, in our multi-asset mandate, we hold some cheap put options that would benefit nicely from a 3% to 5% decline in US stocks in the short term. We remain long Indian equities for what we believe will be a structural bull market in the decades ahead. In fixed income, we own some high quality US bonds both outright and relative to European bonds. In the RMG FX Strategy mandate, we are modestly long of the US Dollar against selected emerging market currencies as we believe there will be a growing shortage of Dollars during the second half of the year.
Generally speaking, our portfolios are positioned to benefit from a risk off type environment, but the amount of capital we are risking is still quite modest as imminent signs of market stress are only just emerging. If we are right that the second half of the year will see greater stresses emerging, we will be looking to add to our existing positions. Needless to say, our performance will be very different from those managers following buy and hold type strategies and of course the ubiquitous ETF industry. Or in other words, we offer potentially great diversification opportunities for active investors with a very well defined and controlled risk process. We look forward to fleshing out our market views in the weeks ahead.
Stewart Richardson
RMG Wealth Management
