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BOJ Monetary Policy: Anticipated BoJ explanation for winding down YCC

How would BoJ explain a decision to dismantle YCC in Oct-Dec 2023?

Possible explanation would be the Bank concluding that it 1) had made "sufficient" progress on achieving the price target or 2) needs to address side effects of policy

We think it would cite both factors and portray itself as "nimbly responding to developments in economic activity and prices as well as financial conditions"

US Fixed Income: Mixed signals = downturn next?

Macro View: The US data continues to send mixed signals with the one shining spot still being the labour market, while the rest of the economy is reacting to the higher level of rates and likely reduced levels of credit. If we look at some of the higher frequency data, such as transportation, the high inventory levels (and potentially less working capital credit) is resulting in declining levels of activity that are approaching what is seen in the sharpest recessions. Something is off in the US economy, in our view.  Overall, we believe many in the marketplace are underappreciating what happens when you reverse the positive rate of change for general liquidity. In a credit-based system, once you get economic actors used to a certain about of credit and more importantly, when the speed goes from ultra-fast to a small negative, that feels like freefall for many within the economy. Assumptions are made in the good times, where the idea is that the good times will continue indefinitely. Meanwhile one should not view the US consumer as one big monolithic entity, it has various cohorts. The lower levels have mostly burnt through their savings post the fiscal largesse. We are seeing in the data a heavier usage of credit cards but at the same time and increase in savings. The saving grace again is the jobs markets. Yet once that starts to soften, the situation can change quickly into a downturn.

Fed Policy: Although it is too soon for them to admit it, but in our view the Fed is likely done with hiking. However, this cycle has been unique in so many ways. The speed and size of the hikes were aggressive, especially after a period of claiming inflation was transitory and the Fed, and it feels like they are not considering the lag effects either. We likely need the Fed to skip a hike at the June FOMC as well as see the dots unchanged for the 2023 terminal level (5.125% - i.e. current levels) for convictions to rise. Meanwhile the re-introduction of the r-star (neutral rate) by the NY Fed could be viewed as the Fed is thinking about raising the long-term dot to something beyond 2.5% (a level its been at since 2019). Arguably the neutral rate is potentially higher given the inflationary frictions (ESG related greenflation, on-shoring of production, labour shortages etc). So, if the Fed skips a hike in June, and keeps the 2023 dots the same, a way to push back against market rate cut expectations is to raise the 2024-25 dots as well as push up the neutral rate to convey the Fed won’t ease back to zero interest rate policy (when they ever start to cut rates in the future).

Rates View: Our rates path is being influenced by two competing scenarios, where both see the Fed cutting rates later in the year, where the key difference is by how much and what will be the catalyst to see them start to ease. If inflation continues to slide lower, the real rate levels will start to turn positive versus a Fed on hold at 5 plus percent. This “immaculate disinflation” along with clearer signs of economic weakness could see the Fed cut by 50bps. Meanwhile if the macro conditions worsen and there are more credit accidents, they could cut by 100bps or more. 

FX Outlook

The US dollar on a DXY basis has gained by about 1.5% since our last Global Markets Monthly with most of those gains coming in the last ten days as investors reduce the size of rate cuts by year-end and begin to price a greater probability of another rate hike from the FOMC in June. Optimism that the debt ceiling issue will be resolved and easing fears over further problems in the US regional banking sector have all contributed to speculation of tighter policy for longer. The 2-year UST note yield is up 45bps since 11^th May. The market continues to expect rate hikes from the ECB and the BoE in June given inflation has been slower to come down in Europe. We are currently expecting a pause from the FOMC and we believe the comments from Fed Chair Powell on 19^th May were consistent with that view. However, data between now and the FOMC meeting could change our thinking. We still see limited scope for further US dollar strength given weakening economic activity and a pause from the Fed before cuts emerge by year-end.

KEY RISK FACTORS IN THE MONTH AHEAD

• We currently have a neutral bias for USD/JPY as we believe the current positive momentum will fade after a notable move to the upside over the last month. The obvious risk here is that the positive momentum is more sustained than anticipated based on for example stronger than expected US data, and a rate hike from the Fed in June. A rate hike according to OIS is pricing is still only estimated to be a 20% probability event but that could change quickly if the debt ceiling issue is resolved and the data from the US is stronger than expected. A pause still seems more likely to us given Fed Chair Powell’s comments but the payrolls and CPI data will be key. The CPI data is the day before the June FOMC meeting. There is a considerable downside risk too. A failure to reach a debt ceiling deal until very close to x-date would likely see USD/JPY a lot lower.
• The main upside risk for EUR/USD in the month ahead would be a more disruptive US debt ceiling outcome that delivers another negative shock to the US economy. Once the dust settles the shock would encourage the US rate market to price back in larger Fed rate cuts. It could also make the EUR appear relatively more attractive as the most liquid alternative reserve currency to the USD. In contrast, the main downside risk for EUR/USD would be if the Fed raises rates again in June and concerns over disruption form the US economy from regional bank problems and the debt ceiling continue to fade. While at the same time, the ECB delivers one more hike but provides a stronger signal that it could be the last hike in the cycle.
• The PBOC remained quite prudent recently, leaving 1-year Medium-term lending facility rate, 1-year and 5-year loan prime rates unchanged. Given that CPI inflation was reaching a near zero level already in April, the weak domestic demand and lack of confidence in economic recovery requires decisive fiscal policies. The risk is that should macro policies fail to lift the sentiment, and the CNY may face intensified selling pressures.