Don't bank on it

April 25, 2016

Can two of the world's largest central banks steer their economies in the right direction and keep the markets happy at the same time? That is quite a question and one to which there is no straightforward answer given the number of variables involved. In fact when I think about this question I am reminded of Donald Rumsfeld's now famous comments at a US Department of defence briefing. In answer to a question from the press he said that

"Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don't know we don't know."

The fallout from negative interest rates could certainly have been included in the last group (unknown unknowns) as perhaps would the return of Yen strength in 2016. Of course these have now emerged and have moved into the known unknown category I would suggest.

Didn't go to plan

We wrote extensively last year on monetary divergence and what that would likely mean for traders in 2016. In the expectation that US interest rates would move higher whilst interest rates elsewhere would stay at or around zero. That has not been the case however. First the Bank of Japan moved interest rates below zero percent and following hard on their heels the European Central Bank or ECB did the same. Meanwhile interest rates in the United States have remained static since the Federal Reserve hiked rates, by 0.25% in December 2015.

The Fed started 2016 by implying that they would raise rates several times in the course of the year. They back tracked from that standpoint in March however. Just as the markets bought into the idea that US inflation was picking up, would exceed the Fed's own 2% target and therefore justify further rate rises.

Whilst we have seen monetary policy divergence it's come from a completely different direction from what was anticipated. Another unknown unknown?

The Federal Reserve suggested last time out that it was on hold because of concerns it had over the global economy. Though the minutes of their March meeting showed that the bank was still preparing for rate rises this year. Markets now put a probability of a rate rise in December 2016 at 65% versus just a 3% chance of a rise on Wednesday evening.

US economy in focus once more

Regular readers will be aware that I follow the Atlanta Fed GDPNow model that tries to predict US GDP on a quarterly basis, through a process known as now casting. The model uses 15 or more regularly updated economic data inputs in its calculations. The model was updated on the 19 of April and now predicts that US Q1 2016 GDP will come in at just + 0.3%. As we can see from the chart that is significantly below the Blue Chip consensus forecast (the grey shaded band) 

The Atlanta Fed GDPNow forecast for US GDP in Q1 2016

[Evolution of Atlanta Fed GDPNow real GDP forecast]

The model has been an increasingly accurate predictor of US GDP and though we won't get the official GDP release until Thursday 28 April, the Fed will surely be keeping a close eye on this key data point.

Underperform rating

Our sense has been for some time that the US economy is slowing down. Regular readers will once again be aware of the fact that we watch the Citigroup economic surprise index closely. To get a handle on how the US economy is faring versus market expectations. We view this index as a performance indicator as well as a gauge of sentiment. Particularly when comparing multiple economies. However in the chart below we look at the US economic surprise index in isolation.

What we find is that having surprised to the upside through the final two thirds of Q1 2016. US economic data has now started to undershoot,disappoint or if you prefer miss analyst's expectations. As we can see the index has formed a "triple top" and could theoretically retest back to the early 2016 lows or even the 2015 "double bottom". To our mind it is domestic issues that will sway the Fed throughout the balance of 2016 and if our thinking is right it will mean that they will defer from further rate rises this year.

Made in Japan

Japan is renowned for its manufacture of cutting edge consumer technology, cars and precision engineering and is often seen as test bed for future global trends in these fields. That stereotyping continues into the financial markets and monetary policy. Where Japan has often been a first mover. Whether it has gained an advantage from being in vanguard of change is very much open to debate.

When we think about Japan we must also consider the juxtaposition of its conservative cultural values in comparison to its opened minded approach to unconventional monetary policy. Which I guess is the kind of thing that makes the country so fascinating and the Yen such a widely traded currency.

The Yen gave ground against the US dollar on Friday (22/04) as rumours circulated that the Bank of Japan would start to lend money, to commercial banks, at negative rates of interest. Effectively paying them to take their money away. That story, how much truth there is in it and what the long term ramifications are probably falls into the category of known unknowns.

Staying with this meme we had data that falls into the known knowns category early on Friday morning. In the shape of the Japanese Manufacturing PMI (or Purchasing Managers Index) for April. A gauge of industrial activity, which came in at 48 well into contraction territory and below forecasts of 49.6. Creating a further headache for BOJ Governor Kuroda and Prime Minister Shinzo Abe.

The Bank of Japan has been buying instruments other than Japanese Government Bonds (JGBs) and in particular Japanese equity related ETFS, it is said that they now own more than 50% of these instruments. We should treat that assertion with some caution but it serves to show the limitations created by the size of the BOJs QE program relative to the size of the underlying markets.

Nevertheless there has also been talk that the BOJ will choose to add to its purchase of Japanese equity ETFs at Thursday's meeting. In this instance then we are faced with a known unknown. Namely what are the consequences of the Central Bank owning more than 30% plus of all JGBs and a large chunk of the stock market? Japan appears to be moving ever closer to a financial twilight zone in which normality no longer applies and in which the use of monetisation (printing cash to pay down debt or spend on fiscal stimulus) or so called "Helicopter money" in which cash is injected directly into bank accounts becomes more likely. Governor Kuroda has played down the likelihood of the use of the latter, but monetisation (which has historically been seen as the last taboo and akin to debasing gold coins) may arrive by default. Where that would leave us is perhaps an unknown unknown.

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