Central Banks 72

09 23 2018 | by Victor Xing | Central Banks

Calm before the storm as quantitative tightening looms

Executive Summary

  • Bank of Japan initiated “reverse twist” by further reducing ultra-long QE purchases and boosting front-end support
  • Looming ECB QE taper and another rise in Fed reinvestment cap by next month will weigh on long-maturity bonds
  • A flatter curve has been instrumental in easing non-bank financial conditions, lowering funding cost, and pushing investors to “seek yield” via riskier assets; thus, higher term premium will likely be bearish to risk asset valuations
  • Market participants continue to debate Fed’s “dot plot” despite risks of regime change faced by long-term bonds

Bank of Japan’s new salvo at quantitative tightening

Cnsistent with Bank of Japan’s willingness to tolerate greater yield deviations from Policy Board’s stated Yield Curve Control target, the central bank has increased buying in short-term JGBs and at the same time dialed back demand for long-maturity bonds to ¥50.2 billion:

BOJ quantitative tightening

This approach is consistent with the “reverse twist” previously advocated by St. Louis Fed President Bullard (as well as other FOMC participants), before the plan was “put to the back burner” following the start of the on-going rate hike cycle:

“That’s something that I’ve advocated in the past, and it seems to me now might be a good time to – or 2017, possibly, would be a good time to play that card. And then we could start working the balance sheet down. And if we don’t want to allow a runoff of the balance sheet, another thing you could do is reverse the Operation Twist that we did earlier and go at a shorter – you know, replace maturing securities with shorter-term securities. You could do that as well.”

President Bullard further suggested that a steeper curve and higher long-term bond yields would allow the Federal Reserve to hike rates more gradually, and the combination of less support toward long-maturity bonds as well as less steep rate path would give policymakers the “appropriate amount of policy tightening:”

“Well, I think you put less downward pressure on longer-term yields, you probably get a steeper yield curve. But in the context of what I’m advocating, which is only one rate increase over the forecast horizon, I think it would probably give you the appropriate amount of policy tightening.”

However, President Bullard subsequently acknowledged that eroding support toward long-maturity bonds would also lift real yields and affect market-implied growth outlook, thus shift Fed’s economic views. This highlights the conflict faced by policymakers – do real yields reflect economic outlook or policy impact? If policymakers formulate responses on the former but impact the latter via unconventional policy tools, then it is likely for officials to create a self-reinforced feedback loop where higher long-maturity bond yields beget further tightening (and vice versa).

The well-anticipated October policy tightening

With a number of market participants aligned with policymakers to view long-maturity rates as a proxy for real growth instead of impacts from balance sheet policy, it is possible for some investors to interpret a steeper curve as a sign of stronger growth outlook. Probability of this scenario is rising as ECB tapers its QE purchases, and the Federal Reserve lifts its reinvestment cap in the coming month to pare balance sheet induced policy support:

quantitative tightening

This perspective may reinforce the view that the October quantitative tightening is well-anticipated and already priced in, and further rises in long-maturity bond yields would be attributed catalysts other than monetary policy. For example, many investors are focused on the September FOMC SEP “dot plot” as the next major policy event.

Given low term premium’s effect in pushing investors to “reach for yield” and moving up the risk ladder, higher long-term bond yields as a result of the looming quantitative tightening will reverse the risk-parity flows to exert pressure on both long-maturity sovereign bonds as well as risk-assets – a scenario that nullifies sovereign bonds’ efficacy as risk hedge.

Next article05 20 2018 | by Victor Xing | Central Banks

Alternative narrative on the natural rate of interest