Yield curves, contradictions and finessing ……..

Thursday 15th September 2016

  

..... more from Central Bank Watch

ref:- "BOE Sees Chance of Another Cut This Year as Rate Held at 0.25%", Bloomberg Markets

Actually, the article in question deals exclusively with the Bank of England's Monetary Policy Committee's unanimous decision earlier today to keep both rates and the programme of bond purchases (QE) unchanged. No one was really expecting any different of course, but one couldn't help noting the contrast between the calmness surrounding the BoE decision and how the market has already tied itself in knots over the decisions to be reached next week by US Federal Reserve and the Bank of Japan.

BoE Governor Mark Carney and his team are doing a decent job of preparing the market for possible future easing without having to pull the trigger again .... or not yet, at any rate. Today's decision was rendered pretty much a foregone conclusion by the resilience of the UK's post-Brexit data, something that must have come as a surprise even to the most optimistic Brexiteers. The robust performance of the economy was evidenced again earlier this morning by August's Retail Sales numbers. These came in at -0.2%, but were expected at -0.4% and were accompanied by a revision to the July figure  --  +1.9% (from +1.4%) , the strongest monthly number in 14 years. On a year-on-year basis, August sales were up 6.2%.

It's easy to look calm if things are going smoothly, or at least more smoothly than expected. But Mr Carney knows that things can take time to work themselves into the data, and that the process of enacting the Brexit decision has to all intents and purposes not even begun. The BoE has done well to look prepared to do what it may have to, but finessing the market it this way may not be enough. Mr Carney is on record as having a distinct distrust of negative rates, and given that the rate is now only 0.25% it's only too obvious that he has little room to manoeuvre on that front. Things may look a lot less serene around Threadneedle St. if it all turns a bit grim.

Observers might want to point out that what the BoE gets up to is, in global terms, of much lesser import the actions of the Fed and the BoJ. It's a fair point too, though you wouldn't have thought so post-Brexit when the ramifications of the UK's decision roiled global exchanges and UK markets, particularly in government debt, were setting the trend. Still, the Fed's decisions will always be the world's biggest gamechanger and that's why the sight of senior Fed officials publicly airing entirely different opinions on rate hikes is so disappointing. We were under the impression that one element of the Fed's game plan was to keep markets calm, not to add to volatility and confusion by repeated contradiction.

You wouldn't believe it from the number of high-profile figures calling for Fed action, but Fed Fund futures now suggest that the likelihood of a hike next week is down to 20%, and 52% by the end of the year. It somehow feels a bigger possibility for Thursday than that but we wouldn't deny that it's unlikely ..... and getting pulled in different directions like that rather illustrates the point. The Fed is clouding the picture rather that clearing it, and to many people's way of thinking is not covering itself in glory.

And so to the Bank of Japan, and just about anything is still possible ..... except helicopter money, of course (theoretically, that's illegal in Japan). What almost all do agree on is the BoJ's desire to steepen the yield curve, and the resulting speculation prompted the huge reversal in Japanese long bonds and widened the premium in yields of the long end over the shorter end in Japan and beyond. In other words, yield curve steepening.

It makes sense that longer-term instruments command more interest than shorter ones, not least due to risk factor increasing the longer the term. Highest amongst the risks is the possible damage done to investments by future inflation. Flatter yield curves suggest a lesser chance of inflation (and by extension growth), which of course is not what the BoJ wants to hear.

Most importantly, the BoJ will want to help Japanese banks by engineering a return to the conditions that a steeper yield-curve brings, allowing one of the most basic tenets of profitable banking to operate  --  borrow short-term (at a lower rate), lend long-term (at a higher rate). To do that, the BoJ might adjust their asset-buying programme to purchase more short-dated debt and less at the longer end. They might also cut short-term rates, currently at -0.1%, to steepen the curve. Trouble is, if they do it that way you've got to wonder whether a move further into negative territory would bring as many problems for the banks as it solves.