We expect the FOMC to hike the fed funds rate at its next meeting, following strong US jobs numbers, rising inflation and a supportive economic backdrop. Franck Dixmier says not doing so would confound market expectations and risk a surge in volatility.
What the market expects from the Fed
We fully anticipate that the US Federal Reserve will announce a rate hike this month. If this is the case, the Fed will have skillfully succeeded in guiding market expectations toward its normalization scenario without any major hitches, albeit at the cost of a marginal increase in long-term rates. On the other hand, postponing the expected hike would send out a confused message to the markets and undoubtedly trigger a fresh surge in volatility.
The Federal Open Market Committee (FOMC) has actively prepared the markets for a hike in the fed funds rate. While the markets initially expressed a degree of skepticism toward the Fed's dot-plot chart (which reflects how the central bank expects it will shift interest rates), they now seem convinced and are pricing in an imminent hike, with implied probability of close to 100%.
The global growth outlook has been revised upward slightly, while market volatility remains at a low level
Underlying trends in the jobs market and inflation rate have provided the Fed with a solid case for justifying future rate hikes. This has been reinforced by a favorable macroeconomic and financial backdrop: The global growth outlook has been revised upward slightly, while an increase in risk appetite has maintained market volatility at a low level.
We expect the Fed will reiterate its resolution to continue normalizing monetary policy
In addition to the expected increase in the fed funds rate, the Fed's policy committee meeting should also provide the central bank with a platform to outline its latest macroeconomic forecasts and set the pace for further rate hikes. We expect the Fed will reiterate its resolution to continue normalizing monetary policy. However, it is too early to announce a reduction in the size of its balance sheet, which has now reached $4.5 trillion. The Fed probably plans to wait for the normalization process to advance further before doing so.
We expect no new actions from the BOJ at their latest meeting. Yet although the central bank is upbeat about inflation, Stefan Scheurer says the BOJ has to pave the way for future yield-target adjustments if inflation disappoints as US rates rise.
We anticipate that the Bank of Japan (BOJ) will announce no new actions at this week's press conference, and it may even wait until the second half of 2017 to discuss its next policy shift. BOJ Governor Haruiko Kuroda will remain upbeat on inflation but will continue to maintain that it is far too soon for the BOJ to consider raising its yield target.
The central bank retains its optimistic view on Japan's inflation path in a continued bid to coordinate higher expectations from the market. Yet the very slight reflation we have seen so far in Japan has been driven more by rising commodity and import prices than any substantive wage growth. Underlying inflation dynamics and indicators remain weak, and corporate concerns about protectionism will keep wage increases down, despite a weaker yen and higher resulting profits. Consequently, inflation remains more or less range-bound and again raises questions about the BOJ's ability to reach its 2% price-stability target.
The BOJ's approach to yield-curve targeting aims at preserving the current level of interest rates and steepness of the yield curve. Lower rates across the curve, as well as the latest acceleration of credit demand from corporations, suggest that this policy is working so far. However, a credible targeting mechanism might require fewer bond purchases in the future, leading to a slower increase in the monetary base going forward.
The BOJ's decision to publish a schedule of regular quantitative-easing purchases has helped calm market worries of possible imminent policy adjustments. However, in a clear sign that the BOJ is running out of ammunition, the central bank has started to lose pace against its stated annual Japanese government bond purchase target of JPY 80 trillion. Instead, it will conduct purchases in a flexible manner going forward – a shift from the monthly JGB purchases of approximately JPY 8-12 trillion before. Moreover, in order to manage the slope of the curve, the BOJ has recently switched from buying JGBs with one- to five-year maturities to those with maturities between five and ten years.
The BOJ's approach to yield-curve targeting aims at preserving the current level of interest rates and steepness of the yield curve
And with higher rates expected in the US and global inflation expected to edge up, maintaining the BOJ's yield-curve target will become increasingly difficult. As a result, we expect the BOJ will maintain its 10-year JGB yield target at "around 0%". However, if the yen-to-dollar rate markedly weakens, it will become increasingly likely that the BOJ will raise its target for 10-year JGB yields. In the months to come, the BOJ will have to prepare the market for an increased yield-curve control target by widening the fluctuation range for the 10-year yield to around +/- 0.20%, gradually hiking the midpoint for this target range in 10- to 20-basis-point increments. Consequently, we will be watching the press conference closely for any indications Mr. Kuroda is paving the way for future yield-target adjustments.