Sayonara negative rates

• Equities prospered - Japanese equities rallied over +5% in sterling terms
• Bonds also rallied, with gilts rising c. +1%

• Sterling weakened against the dollar and the euro
• Equities did rise in Europe and emerging markets but to a lesser extent

Last week was certainly a bumper week for central bankers. In a historic move, the Bank of Japan (BoJ) voted to tighten monetary policy and end its negative interest rate policy, in place since 2016. The BoJ voted to raise the policy rate from -0.10% to 0-0.1%. It also abolished its Yield Curve Control policy through which it bought bonds to control their yields after having previously relaxed it several times. However, the BoJ confirmed it would continue “to buy long-term Government bonds as needed”.

The decision confirmed speculation and arrived earlier than many economists had expected. Despite tightening rates, Japanese Monetary policy remains one of the easiest globally.

The next question on investors’ minds is if the BoJ will continue to hike. Should Japanese monetary policy normalise, this could see an exodus of Japanese flows from the rest of the world back to Japan.

The market expects further hikes - futures are pricing in just over two 25bps increases this year, which would take the policy rate to +0.3% by December. Longer-term indicators suggest the policy rate could be at 0.65% in three years’ time. While this would be significant by Japanese standards, rates there would still be significantly below global peers.

There is also a question of whether this tightening will be possible. While inflation has revived considerably in Japan and wage growth has been stronger, inflation is beginning to moderate and expectations for GDP growth are modest this year.

A final concern is the balance sheet: the BoJ holds assets worth around 130% of GDP and shrinking these holdings will be a delicate process. “Normalising” it to just above required reserves would necessitate the BoJ  selling JPY440trn ($3trn) of assets. Reducing holdings to this degree, assuming the BoJ leaves bonds to mature and does not sell them outright, would take around nine years. A more aggressive approach could reduce the balance sheet more quickly but would likely send bond yields on Japanese Government Bonds significantly higher, which could have an impact elsewhere.

Rates remained unchanged in the US at last week’s Fed meeting, but the market still took the meeting as a dovish signal.

While policy was unchanged, there were some changes to the forecast. Both inflation and growth forecasts were revised up for 2024, modestly in the case of inflation (from 2.4% to 2.6%) and more substantially in the case of growth (from 1.4% to 2.1%). Further out, growth was revised modestly higher in 2024 and 2025, but the inflation forecast was unchanged.

Despite the upward revisions to forecasts this year, the Fed’s own estimate of how much monetary policy should loosen - the Dot Plot - remained unchanged this year, though it indicated modestly less tightening in 2025 and 2026. Given the recent resilience of CPI data, the fact that the Dot Plot continues to indicate three cuts this year was perhaps a relief.

Further relief came from Fed Chair Powell’s comments, which were sanguine on inflation and brushed off concerns about stronger CPI prints as “bumps in the road” - confirming that the inflation “story is really essentially the same.” He also maintained that his confidence measures of rents and rent-proxies should decline.

Overall, the meeting seems to have bolstered the expectation of a first rate cut this June or July.

Like the Fed, the Bank of England also left the policy rate unchanged, though the Monetary Policy Committee sent some dovish signals.

Firstly, the voting pattern changed, with no votes in favour of a hike for the first time since September 2021, compared to two in February. One member continued to favour a cut, as in February.

Secondly, the guidance explicitly acknowledged the space for normalising monetary policy without making it accommodative – “the Committee recognised that the stance of monetary policy could remain restrictive even if Bank Rate were to be reduced, given that it was starting from an already restrictive level.”

Thirdly, the comment recognised the significant drop in inflation, and in inflation forecasts, with CPI expected to fall below 2% in the second quarter, albeit temporarily.

Overall, we still expect the May Monetary Policy Report to unlock rate cuts. More moderate assumptions of rate cuts, coupled with a lower path for inflation, could pave the way for a cut thereafter.

 

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