Was there a “plaza” accord after all?

Published on 17-03-2016 10:25:14

Yesterday’s FOMC statement and Yellen’s press comments were unequivocally more dovish than the markets and we were expecting. Going into the meeting there was a reasonable case for preparing the markets for a rate increase in early summer, given declining unemployment and increasing US core CPI. As it turned out, external factors – perhaps a euphemism for undesirable moves in global markets and the US dollar – were in contrast almost overplayed. For us, “Peak fear” was last month’s story, so why bring it up now?

Exhibit 1: US unemployment and core CPI close to target

Though we would shy from asserting that actual coordination between the Fed, ECB and BOJ has taken place at the recent G20 meeting, central banks may be independent of government but are clearly not, in a policy sense, independent of each other. Focusing only on domestic conditions could easily mean a suboptimal outcome for all due to linkages between economies and notably the world’s reliance on US dollar funding.

It seemed earlier in the year that a go-it-alone policy from the Fed could have emphasised the negative effects of monetary policy divergence – as the ECB and BOJ would have been under pressure to pursue even more aggressive monetary stimulus. In these circumstances where would NIRP end? Bank investors could be forgiven for getting a little nervous.

Now, central banks are on the same page. The Fed is following market-implied rates lower leading to reduced pressure on the dollar. To do so without losing credibility, the Fed has focused on external factors and risks.

In turn (or is that in return?) Draghi’s suggested last week that NIRP may have reached a limit in terms of the ECB’s current thinking. In Japan, the BOJ removed January’s language that further rate cuts would be implemented as necessary from its March statement. The risk of a race-to-the-bottom has clearly diminished. For now at least it would appear that small nations such as Denmark and Switzerland can play with significantly negative rates but the big players have decided not to go any further down that road.

Markets have in our view missed something by remaining focused on moves in exchange rates as the indicator of the success, or otherwise, of monetary policy initiatives. We were much more concerned a month ago about spiralling CDS premia and the related sell-off in bank sector bonds cascading into a more significant drag on credit provision in Europe.

By providing additional funding facilities out to 2021 and as importantly by adding corporate bonds to the ECB’s QE package, the ECB has significantly boosted confidence in the bank sector, Exhibit 2. The effect on the corporate bond market has been immediate with a surge of issuance in the week after the ECB’s announcement, met by enthusiastic investor demand.

Exhibit 2: UK, US, EU Bank sector CDS premia – declining from peak levels post-ECB

Even though the Fed runs looser policy than anticipated, risks remain – we have only days ago highlighted still-high developed market equity valuations and declining earnings trends. But what could have turned a tread-water period for equities into a panic, was a Fed determined to tighten regardless of global factors – and that looks a lot less likely than before yesterday’s announcement.

Another read-across for us is that emerging markets benefit perhaps disproportionately from easier dollar funding conditions. Finally, basic resources and energy stocks – two sectors which have looked oversold on a valuation basis and where earnings estimates for basic resources at least appear to have bottomed – also look on a firmer footing in the short-term.

Quick conclusions
1. In perhaps merely an implicit coordination of policy, central banks may have moved away from race-to-the-bottom NIRP after the G20 meeting. Most obviously the ECB has instead shifted emphasis to asset purchases, to the significant benefit of credit markets.
2. With credit stress reducing in Europe and the dollar under pressure, in the short-run risk assets should continue to perform, especially in emerging markets, energy and commodities.
3. Monetary policy is not the only risk; keep in mind valuations and earnings trends which remain above-average for developed equity markets in general over the medium-term.

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