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Central Bank Fest

Next week is the last big week of the year, and what a week it will be:  Five major central banks meet and at least nine from emerging market countries.  

Norway's Norges Bank is the most likely major central bank to hike its key (deposit) rate (December 16).  It would be the second hike of the year.  The economy is enjoying a solid recovery, and headline inflation rose to 4.6% in November, its fastest pace since 2008.  The underlying rate, which Norway adjusts for tax changes and excludes energy, appears to have bottomed out, and the base effect warns up upside pressure over the next few months.  The unemployment rate fell to pre-Covid levels of 2.1% last month.  

The Bank of England had been in play. However, ideas that this last meeting of the year (December 16) was live has faded, especially given the emergency of the new Covid variant and "Plan B" to resume working from home was announced.  In fact, the market had been downgrading the chances since shortly after the November BOE meeting.  At an implied yield of 9.5 bp, its lowest since March, the December futures contract has nearly fully priced out a hike now.   

Even though Governor Bailey blames the market participants for misconstruing his comments before the November meeting, the guidance in recent weeks has been less aggressive.  And the most outspoken hawk on the MPC (Saunders) has toned down his rhetoric considerably since the emergence of Omicron.  That said, the market remains confident of a hike at the next meeting in February.  

Sterling itself never fully recovered from the BOE's surprise on November 4.  It had been near $1.37 then and fell a nickel by the end of the month. It has been capped near $1.3350 so far in December and recorded a new low for the year last week (~$1.3160) to meet a (38.2%) retracement target of the rally that began in March 2020 from almost $1.14.  While the $1.30 area may offer psychological support, the next (50%) retracement is around $1.2830.   It finished last week with its highest close in six sessions.  Follow-through buying in the coming days could see a test on the $1.3300-$1.3350 area.  A move above $1.3400 would lift the tone.  

The Bank of Japan meeting (December 17) may be the closest to a non-event.  Little is to be done.  Given Omicron, the BOJ will likely simply extend its emergency facilities, even if at reduced levels.  In October, it tweaked its forecasts.  Recall, it shaved this year's growth forecast to 3.4% from 3.8% and shifted half of the cut into next year, revising its projection to 2.9% from 2.7%.  It left the next fiscal year's forecast unchanged at 1.3%.  CPI was marked down to flat from 0.6% for this fiscal year, and the next year and the following year were unchanged at 0.9% and 1.0%, respectively.  

Fiscal policy will help strengthen the recovery, but many observers are not impressed.  This is likely to be reflected in the results of the Tankan Survey to start the new week.  The median forecast in Blomberg's survey looks for the sentiment among the large manufacturers to slip (to 17 from 18), while small manufacturers are expected to see no change (from -3).  Sentiment among the large and small manufacturers is expected to rise but remain at low levels (6 vs. 2,  and -5 from 10, respectively). Capex among the large companies is likely to slow from 10.1% to 9.5%.   

According to the Ministry of Finance's weekly portfolio flow report, foreign investors have sold Japanese shares for the three weeks through December 3. They were consistent buyers since Kishida became the head of the Liberal Democratic Party.  On the other hand, over the past four weeks, foreign investors bought the most Japanese bonds since 2018.  Equity investments typically have lower currency hedge ratios than fixed income.  

The market impact from the BOJ meeting is unlikely to be strong in any event.  The dollar-yen exchange rate is more correlated with US yields than Japanese yields. This year, the yen had been the weakest of the major currencies until November, when the Swedish krona took the dubious honor (~-9.1% vs. -9.0%).  


That brings us to the two more interesting and impactful central banks, the Fed (December 15) and ECB (December 16).   The focus is on the pace of the Fed's tapering.  If the use of the Fed's balance sheet is to be normalized, the expansion must stop when the economic emergency is over.  Even with the emergence of Omicron, the economic emergency has been over for some time.  Moreover, with surging house prices and the use of inflation-protected securities to shed light on inflation expectations, we have argued that the Fed's purchases of mortgage-backed securities and TIPS should have ended at least six months ago.  That said, the exit this time is considerably quicker than last time, though the context is quite different.

Yet, like every Monday morning quarterback, most of whom may not have thrown a pigskin in years, know the play that should have been called, nearly everyone has an opinion on what the Federal Reserve ought to do.  In the first instance, the real trick is understanding what it will do. We think what the Fed will do follows from its strategic objective to maximize its flexibility to respond to the wide range of probable outcomes, which is what heightened uncertainty means in this context. 

The current pace of its tapering means that it will finish its bond purchases around the middle of 2022. This essentially ties the Fed's hands for the next six months.  With inflation still accelerating from elevated levels, this is not acceptable. Hence the need to finish the bond-buying early.  To complete it in Q1 22 requires doubling the current pace of tapering to $30 bln a month starting January.  Of course, some will express concern about the faster pace, but the difference of $1 bln a day in the $550-$650 bln seems like small beer.  

Fed officials will also update their economic projections.  The market appears most sensitive to the "dots" for the Fed funds rate.  Recall that in September's iteration, half of the 18 officials did not think a hike next year would be appropriate, and of those that did, three thought two hikes may be required.  Look for a dramatic change as tipped by the changing tone of the rhetoric and the like decision to finish the tapering early.  

Since the September FOMC meeting, the implied yield of the December 2022 Fed funds futures contract has risen by around 50 bp to two rate hikes entirely, plus roughly a 66% chance of a third hike.  The market has done the Fed's heavy lifting, and the dot plot will play catch-up.  It may be the Fed officials raise their dots by a 25 bp so that the hawks now see three hikes as being necessary, while those expecting one could now see two.  Some of the nine who saw no hike now likely see one.  Some may swing the harder and join the two-camp.  In September, one official (Evans?) did not see a need to hike rates in 2023 either. Might the official still prefer a standpat stance?  

The median forecast (Bloomberg survey) is for the US CPI to peak now and fall to almost 2.5% by the end of next year. The PCE deflator is expected to follow a similar pattern and finish slightly below the CPI next year.  The median projections at the September FOMC meeting have the PCE deflator at 4.2% this year, falling to 2.3% in Q4 22 and 2.2% in 2023. 

Nine Fed officials estimate the long-term equilibrium Fed funds rate at 2.50%.  Two officials are at 3.0%, and one is at 2%.  Five are between 2.25%-2.375%.  Apparently, one did not cast their dot.  The market does not think this will be achieved in this cycle.  The overnight index swaps suggest that Fed funds will peak around 1.50% in 2023.  The terminal rate is important for the valuation of other financial assets.  

It may also help explain another force keeping the long-end lower than economists expected.  Indeed, rarely have the professional forecasters in the Philadelphia Fed survey not forecast higher 10-year yields since at least the Great Financial Crisis.  The low long-term yields and the flatness of the coupon curve do not speak to worries that Fed is behind the inflation curve but are consistent with growth concerns.  The US budget deficit is expected to be roughly halved next year.  The peak in monetary accommodation has passed.  The high savings rate is being drawn down by consumption (and higher prices) and the resumption of rent and other debt obligations.  While the US economy is accelerating after the disappointing Q3 2.1% annualized pace, economists in the Bloomberg survey see the economy consistently slowing sequentially every quarter next year.  

The ECB is a different kettle of fish.  The leadership is less worried about inflation than its American counterparts. The Fed's Powell has eschewed the "transitory" characteristic of inflation, but he still seems it most likely falling back in the second half of next year.  ECB President Lagarde has not given up on the temporary nature of the inflation pressures and recently referred to it as a hump.  A recent BIS report estimated that without the supply chain disruptions eurozone inflation would be closer to 1.5% (with the US at 2.5%).  

The critical debate at the ECB meeting is over the modalities/dimensions of the bond-buying program after the Pandemic Emergency Purchase Program is allowed to end as planned in March.  The Asset Purchase Program that was in place before Covid struck has continued at a pace of around 20 bln euros a month.  The self-imposed restrictions played a role in the judicial decision that it was within the ECB's remit (having been challenged by the Bundesbank, setting precedent for Poland and Hungary's charges that the ECJ had overstepped its authority).   Many look for it to double after the PEPP ends, which may also diminish the fear of a buying cliff or an abrupt stop that provides the rationale for tapering in the first place.  

Currently, the forward guidance is that the purchases will end "shortly" before the ECB starts raising its key rates.  The hawks may seek to place a time limit so as not to commit the ECB to "QE-infinity" with elevated inflation.  A 3-6 month period before reviewing could be a workable compromise.  Operationally, some other limits may be reconsidered, such as the ban on Greek bond purchases.  The ECB could also announce an extension of its long-term targeted loan program (at as much as minus 100 bp if loan objectives are met).  However, delaying some decisions into next year seems prudent given the uncertainty.  That said, given the notorious collateral shortage, the ECB should ease and extend its securities lending efforts or offer a reverse-repo-like facility, similar in concept to the Fed's, but it probably won't. 

Interestingly, the Bloomberg survey shows the median view is for EMU inflation to peak this quarter and fall back below 2.0% by the end of next year.  The ECB's staff's September forecasts saw CPI peaking this year and falling to 1.7% at the end of next year and 1.5% at the end of 2023.  There is speculation that the 2023 forecast could be revised higher, but at long as it and the 2024 estimate is below 2%, the doves have a powerful argument on their side.   

Brief Thoughts on EM Central Banks

Emerging markets are not homogenous.  Except for South Korea, which has hiked the bank rate twice this year (to 1.0%), most other central banks in the region have stood pat.  Indonesia, the Philippines, and Taiwan are expected to standpat in the week ahead.  The tightening cycle in central Europe and Latam is advanced.  

All rate hikes are not the same.  Russia and Hungary's central banks meet next week.  They are experiencing solid growth and rising price pressures. The 100 bp hike that many expect from the Russian central bank (December 17) would lift the key rate above the inflation rate, albeit barely (8.5% vs. 8.4% November CPI).  Since hiking the base rate 30 bp to 2.10% on November 16, the Hungarian central bank has lifted the 1-week deposit rate by 150 bp to 3.30.  At December 14 meeting it is likely to raise the base rate by 50 or 75 bp. 

Turkey's central bank meets on December 16.  Since the central bank cut the one-week repo by 100 bp on November 18, the lira has depreciated almost 20% against the dollar and brought this year's drop to more than 45%.  November CPI edged above 21.3%, and the core rate was a little above 17.6%.  Some economists thought the lira was cheap to fair value months ago, but the loss of central bank credibility may not be quantifiable.  Ultimately, the era of floating exchange rates is a confidence game to a large extent, and it has lost it. 

The rate cycle is well underway in Latam, but the rate hikes are mainly coming despite soft growth.  Price pressures seem to be the main driver. Chile (December 14), Mexico (December 16), and Colombia (December 17) are expected to extend their tightening cycle.  Chile and Colombia are seen raising key rates 125 bp and 50 bp, respectively.  The market anticipates another 25 bp hike by Mexico, but the risk of a 50 bp move at Governor Diaz's last meeting seems greater than standing pat, especially after last week's news that November CPI surged to almost 7.4% from about 6.25% in October. 

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Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.
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