BIL - Tighter Policy All Around

2023-07-31 10:30:00 ET

Summary

• Major central banks tightened policy last week, including unexpectedly in Japan. We see the potential for rising Japanese bond yields to pull global yields higher.
• The Bank of Japan tweaked its yield cap, sending local yields to a nine-year high. Developed market stocks hit 15-month highs.
• U.S. jobs data this week is likely to show still-low unemployment, confirming a tight labor market. We see weak euro area activity as rate hikes bite.

Transcript

The Bank of Japan - or BOJ - took another step last week to wind down stimulus by loosening its policy of capping 10-year government bond yields.

Both the U.S. Federal Reserve and the European Central Bank also hiked last week, and we see them all holding policy tight - and see rising bond yields in Japan pulling global yields higher.

1) Global spillovers

This gravitational pull - from Japan to interconnected developed market bond yields - matters for markets. And it’s gone relatively smoothly for now.

The BOJ’s move to relax its yield curve control is an important development: it’s gradually joining the global policy tightening campaign, in this case letting long-term government bond yields rise.

2) U.S. holding policy tight

The Fed knows that it needs economic weakness to bring inflation down. But it’s not yet convinced that inflation is on track to hit its 2% target.

Coupled with U.S. activity data last week that were also stronger than expected, we see the Fed holding policy tight for longer than markets currently expect.

3) ECB holding policy tight

Like the Fed, the ECB also tightened policy last week - and believes that some economic weakness is needed to bring inflation back down to its 2% target.

The ECB may have hiked for the last time - but it will still hold policy tight even as further weakness materializes, given its determination to bring inflation down at all costs, in our view.

We tactically prefer European bonds to U.S. peers, as market pricing better reflects rates staying higher for longer, and we’re underweight Japanese bonds on the risk of a further rise in yields.

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The Bank of Japan surprised markets last week after it tweaked its yield curve control policy again, joining a tightening wave across developed markets (DM). The Federal Reserve hiked rates and said more could come: it may be overestimating the economy’s strength, we think. By contrast, the European Central Bank signaled an end to its tightening bias and a new phase of data dependency. We see global yields rising with tighter policy all around and favor European bonds in DM.

Upwards together

The Bank of Japan (BOJ) took another step last week to wind down stimulus by loosening its policy of capping 10-year bond yields. The shift saw Japanese 10-year yields rise to a nine-year high. Most global yields rose as well, highlighting why the BOJ move matters for markets - the gravitational pull between DM bond yields is strong. Take the 10-year bond yield of U.S. Treasuries and the average DM peer: they have largely moved in lockstep for decades - apart from 2015-2020 when the euro area and Japan were fighting deflationary risks with negative interest rates and hefty bond purchases. See the chart. We think the BOJ’s move to relax its yield curve control is an important development: it is gradually joining the global policy tightening campaign, and in this case, policy is about letting long-term government bond yields rise. We see potential further tweaks to BOJ policy pulling up developed market bond yields alongside Japanese ones.

The BOJ unexpectedly shifted its hard yield cap up to 1% from 0.5% but kept the half a percentage point range either side of zero as a “reference point,” allowing flexibility on bond purchases. Inflation has returned but not as much as in other economies - and the BOJ is unsure if higher wages will be sustained and keep inflation around its target. The BOJ is still projecting inflation below target a few years ahead but sees a risk of higher-than-forecast inflation in the interim. We expect the BOJ to let yields rise as inflation gets more entrenched, but only gradually. This is a form of tightening, in our view. It has gone smoothly for now, but we think the muted market response may embolden the BOJ to do more - though it could become trickier. It may be some time before the BOJ lifts short-term policy rates from the current -0.1%.

The Fed and ECB have a different problem: inflation is still too high. Last week’s U.S. PCE inflation and wage data showed a move in the right direction. But we fear an inflation rollercoaster as service price pressures persist - and jobs data this week will be key to assessing the outlook. The Fed, like us, is not yet convinced that inflation is on track to reach its target. It thinks economic weakness is the only way to get there - and sees resilient GDP and consumer spending as signs the demand in the economy is still too strong. We think the Fed may be misreading the economy’s strength based on low unemployment: that shouldn’t be taken as the usual sign of a buoyant economy, but rather a result of structural worker shortages holding back growth potential. We think this perceived strength raises the risk that the Fed hikes more than markets expect and then cuts as it generates too much weakness - rather than just holding tight.

The ECB also believes economic weakness is needed to get inflation down to target. It hiked again last week but signaled an end to its tightening bias and a new phase of data dependency. The ECB recognizes that it’s already causing damage, as seen in PMIs. Yet, we still see it holding policy tight to get inflation right down even as more weakness emerges.

Bottom line

We see the BOJ’s shift confirming why DM yields are likely heading higher as investors demand more term premium for the risk of holding long-term government bonds. We stay tactically underweight long-term bonds but see key regional differences. We tactically prefer euro area bonds to U.S. peers, as market pricing better reflects ECB policy staying tight. That view played out this week with euro area yields flat while U.S. and Japanese yields climbed. We stay underweight Japanese bonds given the scope for a further yield rise. We also have a relative preference for high-quality credit for income.

Market backdrop

The BOJ’s tweak to its yield cap drove Japanese bond yields to nine-year highs and pulled along some other DM yields, with the U.S. 10-year Treasury yield up 10 basis points on the week to near 4%. The MSCI World index of DM shares edged higher on the week to hit a 15-month high. Mega-cap tech firms met a high bar in delivering on expected second-quarter earnings. Analysts are eyeing an earnings recovery beyond this quarter, but we expect them to stay under pressure over the next year.

This post originally appeared on the iShares Market Insights.

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