Central bank watcher: Time to deliver

It looks as if the Federal Reserve Bank (Fed) will take the lead among the four major central banks. The European Central Bank (ECB) and the Bank of Japan (BoJ) have hinted at but not yet delivered fresh stimulus in order to not create the impression that they are “outdoving” the Fed and embarking on a currency war with the US. The Fed will almost certainly cut rates in July and pave the way for the others to follow through. The market has started to price in quite a bit of easing, so central banks had better deliver or else will run the risk of a fierce response in risk assets.

The Fed looks set to deliver an ‘insurance’ cut at the 31 July meeting. The main question now is by how much they will reduce rates at this meeting. In our opinion it makes a lot of sense to cut rates by 50 bps, get ahead of the curve and take the angle about the lingering talks about currency intervention.

But, their communication in the past weeks has been hinting more towards a 25 bps cut, which makes this the more likely outcome. Some important data have indeed improved since the June meeting, with payrolls and retail sales surprising to the upside, and the US and China agreeing to a sort of “trade truce”. That might tempt them to think 25 bps is enough. We think the market will respond negatively to such decision, but this Fed still looks less in tune with markets than its predecessors.

Unfortunately 25 bps won’t do the job. It will not be enough to convince markets and corporates that the Fed will do everything it can to sustain economic momentum. It will not be enough to put some downward pressure on the dollar and thus stop the rumors about currency intervention.

A 25 bps move will also lack the power to lift inflation expectations. Hopefully the FOMC members acknowledge this and cut by 50 bps. If not, the response to a smaller cut will probably force them to cut rates again in September. So, in both scenarios we expect rates to be cut by 50 bps by September. The main risk to this scenario is that the Fed will have to deliver more cuts. (See also: The Fed’s sugar rush rally and More repression to avoid recession).

A rate cut in September seems pretty much a done deal now. We think there is a 50% chance of a 20 bps (rather than 10 bps) move. As we believe the risks are skewed to further rate easing – certainly if a tiered reserve system is implemented – we agree with the market discount of c. 25 bps of rate cuts by Q1 2020 – even though our central scenario is for 20 bps (see table below). That said, we do not exclude the possibility that instead of “tiering”, the ECB opts for sweetening the terms of the TLTRO3s as a mitigating measure.

As regards Chinese policy rates, PBoC Governor Yi Gang recently stated that “lowering interest rates is mainly to tackle deflationary risks”, and that, given the moderate inflation (2.7% in June), current levels are “appropriate”. However, he also pointed to the pending reform of the interest rate framework that could indirectly lead to lower borrowing costs for the real economy.

Given the downward impact on bank’s net interest income from the envisaged reform and the reduction in bank lending rates, we still believe there is a more than decent chance the PBoC cuts the 7-day reverse repo rate. While markets discount 5 bps of easing in 7-day interbank repo market conditions by year-end, we see risks as skewed to somewhat stronger easing.

The BoJ is likely to stick with its basic yet unrealistic expectation for domestic demand to strengthen in the second half of 2019 – and is unlikely to introduce sudden and major easing that would be accompanied by negative side effects. (Aggressively) extending forward guidance appears to be the most likely way to expand easing, as it would achieve this at the lowest possible cost and would limit some of the upward pressure on the yen. It would also give the BoJ some time to assess the medium-term impact on the yen of central bank easing elsewhere.

Further monetary policy easing is likely only in 2020. Specifically, we expect the BoJ to extend its forward guidance, signaling that it would maintain the “current extremely low levels” of policy rates to “at least through around end-2021”, thereby adjusting its timeline from its previously indicated “at least through around spring 2020.”