The Fed’s hidden hand in global monetary policy

The surprise interest rate hike by the Bank of Canada (BoC) last Wednesday after a similar surprise by the Reverse Bank of Australia (RBA) unsettled US yields a bit and made us debate whether the BoC and RBA actions have a read-across to the US Federal Reserve (Fed).

Both banks restarted rate hikes after a pause amid worries about more persistent inflation pressures. The Norges bank hiked rates after a pause earlier, and Norwegian inflation numbers unexpectedly accelerated last week. Some talking heads in the market say this indicates an increased willingness of central banks to surprise markets.

Could this raise the likelihood the Fed might have a surprise in store as well? Tim Drayson, our Head of Economics, doesn’t think a June surprise is likely, though a high CPI print just ahead of the decision could change that assessment.

Follow the Fed

So, what could explain the fact that the central banks mentioned above seemed trigger happy?

Canada, Norway and Australia are small, open economies in which exchange rates have an outsized influence on inflation. They are raising interest rates in part because they think the Fed will hike once more, and if they fail to match this they risk foreign exchange depreciation that would add to domestic inflation pressures.

As Willem Klijnstra, one of our strategists, often states, the Fed is the price-setter here, and the other central banks are the price-takers.

Where next for the Japanese yen?

Another currency whose strength is strongly influenced by US monetary policy is the Japanese yen.

The yen is cheap. Very cheap when looking at real effective exchange rates, but also cheap on any other alternative valuation approach. Japanese equity markets are reaching highs not seen since the asset price bubble burst in the early nineties, so should we expect the yen to follow? In our view, no.

As long as the Bank of Japan (BoJ) is on hold, we believe the yen will be a US duration trade. With interest rate differentials widening the yen has stayed rather weak, only adding to the cheapness of the currency. A US recession with Fed rate cuts and lower equity markets could see the yen’s safe-haven status return, but as this will be the most anticipated US recession ever, investors may be disappointed. Also, this may crush any hopes for a return to sustainable inflation in Japan.

We can only see that longer-term valuation gap narrowing significantly if and when the BoJ abandons its negative interest rate policy; tweaking or abandoning yield curve control is not enough.

Some make the argument that any downside to the yen is limited by the threat of intervention by the BoJ, as they did recently at a level of 150 yen to the US dollar, but for the BoJ it’s more about managing volatility (speed of depreciation) than level per se, so we don’t expect any support soon.

We choose to stay on the side-lines for now, with a negative bias to the yen, and will only pursue the value in the yen if and when negative interest rates are bound to disappear, or ideally a little bit before that.