Global Policy Convergence

Quick post here. Markets are already on to this. But the Fed will soon be joined by other central banks in tightening policy. Where I spoke of policy divergence last September, now we can speak of policy convergence. And as usual, it’s Lael Brainard who has her finger on the button.

Policy convergence foreshadowed

Here’s how I described the scenario six months ago. St. Louis Fed President Bullard also features prominently here.

Three years ago, the Fed had begun tightening and all other central banks were still on easy street. Now, we are at an inflection point where the Fed is now the outlier. Other central banks are likely to tighten more than the Fed. That’s negative for the US dollar and positive for longer duration US Treasuries.

In the end, the Fed paused all of the second half of 2017 as it started its quantitative tightening program. As I wrote in September, the initial implication of the policy convergence foreshadowing was curve flattening and a dollar selloff. And that’s what we got.

The Fed initially avoided double-barrelled tightening

But a lot of this was driven by concerns of economic weakening that Bullard made plain.

…But recently, there has been a shift in Fed policy – I think toward dovishness. St. Louis Fed President Jim Bullard has been way ahead of the curve here because he foreshadowed the shift in February…

What Bullard was saying in February was that if the Fed raised rates too quickly, it would flatten the yield curve and could choke off recovery. He said in February “adjustments to balance sheet policy might be viewed as a way to normalize Fed policy without relying exclusively on a higher policy rate path.”…

The balance sheet will come into play rather than rates.

The evidence that this turn is happening is mounting.

Fed Governor Lael Brainard is a good bellwether here since she foreshadowed the last Fed pause in 2016. In a speech earlier this week, she said, “it could take a considerable undershooting of the natural rate of unemployment to achieve our inflation objective.” That’s Fedspeak for “we don’t have to raise rates as aggressively as we’ve been saying we would. Why? Because I think there’s evidence we can let the unemployment rate go really, really low before we have to raise rates due to any worries about inflation.”

A couple of things. The Fed avoided raising rates while the quantitative tightening regime got underway. But curve flattening ceased to be a trend as we moved toward the next Fed rate hike in December. It became clear that a synchronized global expansion was underway.

The policy shift

Notice that back in 2017 Brainard had been talking about letting the unemployment rate undershoot. She echoed these comments in the speech she made this week. But those comments were peripheral to the main point that headwinds were now tailwinds. That shift was developing as Yellen departed. That’s why the yield curve stopped flattening. But, at the Fed, the regime shift only crystallized once new Fed Chair Powell was firmly in place.

Policy convergence coming

But I reckon the next big thing for the markets to digest is policy convergence. We had the foreshadowing of it back in September. In terms of the timetable, the sequence was this:

  • September 2017: The initial monetary policy convergence foreshadowing never dominated markets in 2017. Concerns about overtightening in the US were too acute. That meant US curve flattening and dollar weakness.
  • December 2017: Signs of durable synchronized global growth took hold by early December. Curve flattening stopped and the focus became the Fed’s forward guidance as markets climbed ever higher.
  • Early 2018: The synchronized growth scenario became anchored as signs of Fed hawkishness mounted. This caused Treasuries to sell off and led to predictions of a bond bear market. Equity volatility is (permanently) higher and the short volatility trade will fade.
  • March 2018: With regime shift now fully developed, attention has to turn back to convergence. That means first the ECB, followed by other European central banks and the Bank of Japan. Canada, Australia and New Zeeland won’t play a big role.

So the real question now is less “how many rate hikes will the Fed deliver?” and more “When will QE end in Europe and Japan and when will negative rates there come to an end.”

Takeaway: Watch the ECB

I wrote this up on Twitter earlier today:

As Marc Chandler wrote back in January, “For the past two years, the central banks have bought all the new government bonds issued by the G10. This year, they will buy around 40%.” To me, that’s what will drive global markets in 2018.

So, yes, Brainard’s speech this week was significant. I think it is perhaps the most important Fed speech since the crisis because it marks the beginning of the end of this business cycle.Can the Fed increase rates at a faster rate this late into a business cycle and expect a soft landing for the economy? That’s where we now are. I say no.

Nevertheless, we should look to the ECB more than the Fed now. The market has anticipated the Fed move. The ECB, SNB and BOJ moves are yet to come.

P.S. – Watch Jens Weidmann in particular. Some economists think he’s the most dangerous man in Europe And he could soon be the head of the ECB to replace Mario Draghi.

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