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#Investments — 15.06.2018

A Series Of Central Bank Decisions

Edouard Desbonnets

The Fed pursues its monetary tightening cycle. The ECB is set to follow suit. Central banks in China and Japan remain cautious.

The US Federal Reserve

On Wednesday 13th June, the US Federal Reserve (Fed) lifted interest rates by 25 basis points, taking the target range for the federal funds rate to 1.75%-2%. This (unanimous) decision was widely anticipated by the markets as recent macroeconomic data had been robust.

This is indeed how Fed Chairman Jay Powell began his press conference: "The economy is doing very well." Indeed, growth is strong, unemployment is low and inflation remains in check, at around 2%. Everything was in place for the seventh rate increase in this monetary tightening cycle that began at the end of 2015, and the markets digested the anticipated announcement without any hiccups. The financial conditions remain accommodative according to the Fed and further rate hikes are to be expected. 

Analysts have been focusing their attention on the Fed's new projections for macroeconomic data and interest rates.

Macroeconomic changes are relatively minor. The Fed expects slightly more growth this year (2.8% vs 2.7% expected in March). It revised down its unemployment rate forecasts: 3.6% in 2018 (-0.2%) and 3.5% (-0.1%) in 2019 and 2020 respectively. Inflation was marginally revised up for 2018: 2.1% (+0.2%) and 2019: 2.1% (0.1%). Therefore, it remains at the target level of 2%. Mr Powell, however, was not ready to declare victory on inflation and insisted that he would not react if it temporarily moved away from the target. He hinted that inflation should accelerate in the coming months as oil prices had risen. The medium-term inflation driver is linked to wage growth in a tight labour market environment. In short, these macroeconomic changes reflect the consequences of Trump’s fiscal policy (tax cuts for individuals and businesses, increase in government spending). They show that the expected effects will be short-lived because the Fed's long-term growth is only 1.8%.

In terms of rate hike forecasts, the Fed has brought forward its monetary tightening cycle.  It now plans two more rate hikes by year-end, i.e. one more than previously, but one less in 2020. The new sequence is therefore two more increases this year, three in 2019 and one in 2020. This scenario is based on median estimates of 15 officials, and the dispersion of estimates is low for 2018, with no clear consensus for 2020. In any case, this takes the median rate at the end of the cycle to 3.375%.

The Fed's sequence is now relatively close to ours because we also forecast two additional rate hikes this year (in September and December) and two rate hikes in 2019. The difference is that we believe that the monetary tightening cycle will end in 2019, as growth is expected to decelerate and therefore our end-of-cycle rate is 3%. 

The Fed intends to improve its communication to the markets and will therefore hold press conferences from next year after each FOMC meeting, as opposed to every other meeting currently. The underlying consequence is that the Fed is giving itself more room for manoeuvre, because in the past, it did not usually take major decisions when there was no press conference. 

Finally, the Governing Council is expected to onboard two new members soon. Richard Clarida (Vice-President) and Michelle Bowman have been approved by the Senate Banking Commission. They now need to obtain approval from the full Senate. Both are seen as rather centrist and should therefore help to gradually move the Governing Council's general view away from its dovish (accommodative monetary policy) stance. 

The Chinese Central Bank

The Chinese Central Bank (People's Bank of China - PBOC) met just after the Fed. The markets expected the PBOC to (more or less) follow suit to avoid the risk of a flight of capital, but this did not materialise. The PBOC decided to leave rates unchanged at 2.55% due to internal and external risks. Indeed, even though economic data are improving, they are still rising more slowly. This is particularly on account of the government's fight against shadow banking (unregulated credit instruments), which is contributing to tighter lending conditions. On the other hand, the PBOC certainly wanted to be cautious, in a context of trade tensions with the US, just ahead of the publication of the list of Chinese products that will soon be taxed more heavily by the Americans.  

The European Central Bank

On 6th June, Peter Praet, the ECB's rather dovish chief economist had triggered a market reaction following a speech in which he stated his confidence in the trajectory of inflation. By making a number of assumptions, he concluded that inflation would reach a lower level but close to 2% in the medium term, which represents the ECB's target level. 

The ECB confirmed these data in its new economic projections. It indeed revised up its inflation figures to 1.7% (+0.3%) for 2018 and 2019 due to the appreciation of oil prices and more wage pressure associated with high levels of employment. In terms of growth, the ECB revised down its forecasts for 2018 due to protectionist risk and trade tensions: to 2.1% from 2.4%, but maintained its forecasts of 1.9% for 2019 and 1.7% for 2020.

With the inflation projections close to the target, and after five years of growth, the ECB announced that it would gradually turn the page of a very loose monetary policy. It therefore formalised its intention to put an end to its asset purchase programme at the end of the year. Thus, it will continue to buy assets (mainly sovereign bonds) worth up to €30 billion per month until September, and will reduce purchases to €15 billion per month until December. Next year, it will not buy any assets, but will simply reinvest maturing bonds. This will not have a neutral effect as these are estimated at a little over €15 billion per month in 2019, although this represents a decline in total purchases (net and gross/reinvested) of around 50%.

The ECB, however, tempered its monetary policy normalisation rhetoric by stressing that rates would remain low for a long time at least until the summer of 2019. These words led to a depreciation in the euro and a fall in bond yields as the markets had already priced in a 10 basis point rise in the deposit rate from June 2019.

This immense caution also obliges us to move back our scenario somewhat.  Thus, we shift our expectation of a deposit rate rise initially scheduled for June 2019 to September 2019, but still expect an increase in the key rate at the end of December 2019. 

The Bank of Japan

The BoJ (Bank of Japan) confirmed (unsurprisingly in light of the recent decline in inflation) that it would keep rates unchanged at -0.1% and maintain the 10-year yield at around 0%. The pace of asset purchases remains unchanged. The markets do not expect inflation to return to 2% before 2023. The BoJ, whose mandate is to ensure price stability at 2% and overall stability of the financial system, is likely to be the last central bank to maintain a very accommodative monetary policy for a few more years. 

Conclusion and market reactions

The Fed's decision was widely expected, which explained the subdued market reaction after the announcement. However, this was not the case in relation to the ECB, which was globally dovish, despite its message to end the asset purchase programme. The ECB succeeded in reassuring the market by promising low rates over a long period of time. This explains why the German 10-year yield dropped to 0.43% (-6bps over the day) and Italian yields fell by the same order of magnitude, while the US 10-year yield fell by only 2bps to 2.94%. The biggest change was in the foreign exchange market. The euro depreciated by more than 2% pushing the EUR/USD under 1.16 and helping the eurostoxx 50 to gain more than the S&P 500, with 1.37% vs 0.25%.