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By Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,
Week-in-brief: Of Headlights & Headlines
As headlines go, the FOMC will be center-stage; with very few contenders to steal the show. And with Fed officials mostly converging on the assessment of “transitory” inflation – dispelling undue panic over the larger than expected jump in US CPI – a sufficiently dovish Fed will probably provide adequate reassurance to avoid a “deer in the headlights” moment.
To be sure, we expect that the FOMC (Wed) will be unequivocally dovish, and perhaps still in the process of transitioning to “thinking about thinking about” taper.
But that said, with expectations riding high for dovish conviction, any incremental emphasis on “state dependent” FOMC outcomes and/or “Dot Plot” tilting rate hike expectations a little sooner (than a rate hold through 2023) could still trip up ultra doves.
And this, while not a deer in the headlight bumper shock, could still be a headline that gives markets cause to reassess and re-group; around yields and the USD. The resultant lift in yields (likely more accentuated in real yields) may then stir up volatility in markets.
And later in the week, the BoJ (Fri) has the unenviable task of picking up where the Fed left off; and convincing markets that it will be distinctly (and more durably) dovish than the Fed.
USD/JPY is the key barometer of the BoJ’s success in establishing a justifiably more dovish stance; something the ECB took a stab at last week in declaring the Euro-zone lagged the US, and to great effect as it managed to subdue EUR despite upgrade to economic indicators.
In Asia, Bank Indonesia (Thu) will have to sit on its hands despite lingering, if not growing downside risks to growth from Covid re-emergence.
Macro-stability consideration will be a key restraint; even if the rupiah is currently spared any undue stresses. Especially as real rates have probably bottomed.
The RBA (Tue) and RBI (Fri) will be releasing Minutes, but expect nothing that moves headlines as both central banks will convey holding the wheel steady on policy accommodation.
A strong read of Aussie jobs (Thu) though could have some potential to be mini headlights for AUD bears if downside pressures below 0.77 do not let up post-FOMC.
Knowing that headlines these days may startle markets like a deer in the headlight, the challenge for policy makers is to ensure that their energies create more light than heat (or noise; keeping with the principles of energy conversation).
FX Theme: Keeping It (NEERLY) Real
Approaching a FOMC where dovish bets appear saturated, and CNY bulls being restrained by the PBoC concerned about rich CNY NEER at post-2016 highs, FX markets have to pay attention to how real UST yields behave (having a large bearing on the USD) and how CNY NEER dynamics impact CNY setting.
In other words, keeping it NEER-ly real will be the what really matters for FX markets, especially AXJ.
The FOMC could potentially have huge sway on bond markets, and in turn with spillover impact on FX markets; followed by BoJ later in the week. In particular, USD may be subject to a good deal of volatility, and potentially some re-think, depending on the FOMC. And in the mean time, bets either way may be cautious. Especially as UST bond yields have fallen considerably – despite a larger than expected jump in US inflation – which has resulted in lower nominal yields, and an even larger capitulation in real UST yields.
What this means is that real UST yields could be highly sensitive to any dovish disappointment (signals that come across less dovish than hoped for) accentuated by UST markets steeped dovish Fed bets. Specifically, this may translate to a USD squeeze despite “risk on” in wider asset markets.
Point being, even if markets are convinced about a soft/mellow USD being supported by the wider intent of the FOMC, stretched positioning for an ultra-dovish FOMC outcomes at a a time when inflation continues to rise constitutes latent USD volatility around the FOMC reactions.
Simply put, risk-rewards tilt warns against stretching USD shorts and UST bond longs (lower USTY yields).
And for AXJ, apart from USD volatility, rich CNY NEER resulting in some pushback from the PBoC means that the ability of AXJ to ride on a stronger CNY may be running out of gas.
So more caution and consolidation may be the game-plan as FOMC outcomes are awaited.
US Treasuries: Dovish FOMC Mostly Priced-In
Ahead of FOMC, UST yields have bull flattened with the 10Y tumbling below 1.5%; and this was in spite of US CPI out-running already elevated expectations to 5.0%.
What gives? It appears that despite bleeding out a little but more inflation drivers were sufficiently concentrated in the “re-opening” categories and used autos (accentuated by the chip shortage) to pass off as “transitory” and as such to be overlooked by the Fed.
And it is likely that bond markets will continue to bet on a dovish Fed; hence be in no rush to lift long-end bond yields. In particular if markets are hopeful for more dovish balm.
But that said, with the bets already heavily laid on a dovish Fed, the risk-rewards of pushing for bullish long-end bond prices (10Y yields lower) may not be as desirable. As such, pre-FOMC, downside in 10Y UST yields is likely to be twitchy, with snap-back risks growing at the 1.36-1.38% region.
Meanwhile, if the Fed indeed concedes some ground on the need to start thinking about calibrating unprecedented stimulus, then an upswing in 10Y UST yields to 1.55-1.68% range is a very real risk that cannot be dismissed.
FOMC: Between & Below the Lines of a Dovish Fed
The question that demand answers, especially for those concerned about the minority of FOMC members flagging up the need to soon address the need to discuss exit in the last FOMC Minutes, is how soon, and to what extent thet Fed may allude to exit plans; and in particular, “taper”.
The short answer is that this is a negligible risk at this juncture. At least because the Fed will be very careful not to make sudden and unexpected moves. In particular, with the Fed still seen transitioning to “talking about talking about” taper.
That is to say, this meeting is unlikely to deliver a hawkish jolt via a warning shot on “exit” talks. And certainly, there will be no reference to stepping down the US$120bn/month pace of QE.
But to be very sure the rhetoric that matters may be between, and below the lines; so to speak.
Starting with “below the line“, the “Dot Plot” will be the most important “non-verbal cue”. Any shifts to bring forward the consensus rate hike initiation will be read as being latently hawkish.
As for “between the lines“, even without discussing exit strategies, a more distinct emphasis on “state dependent” outcomes could also be seen as a warm-up act for “taper”; which has been flagged as being scheduled for “well before” any rate hikes.
On the nose would be any reference to discussions on exit strategies; and this could range from merely exploring the need for; or as committed as delving into potential time-lines.
While the latter (“on the nose”) is highly unlikely, the former two could come in some shape or form. But here’s what’s pertinent. With a fairly dovish Fed already baked in (slumping UST yields), the bar for lifting (nominal and real) yields may be a tad lower than is widely appreciated; and that may have a corresponding potential for USD squeeze, even if only fleetingly so.
BoJ: Dovish Hold & JPY Gauge
We expect the BoJ to stay on hold, but continue to emphasise the dovish bias. A key thought here is that the BoJ must entrench the notion that the BoJ’ s dovish time-frame will outlast the Fed’s and thus necessarily will lag the Fed’s “exit” plans.
This highlights how the bumpy emergence from COVID, what becomes increasingly important is not the absolutes of monetary policy; but the relatives. Not the least of which is how a central bank’s exit strategy measures up against, and specifically lags, the Fed’s. On which the ECB presented a master-class on this last week;
i) simultaneously delivering upgrades to economic forecasts, yet;
ii) assuring markets that they will not exit prematurely; even sneaking in the reference of the Euro-zone recovery not being in the same vicinity as that of the US.
Upshot: BoJ will have to address both the stark realities (of US recovery prospects getting well ahead of Japan both on vaccination lead and fiscal out-run); as well as market perceptions of BoJ’s constraints relative to the Fed’s “flexible average inflation” approach to policy.
And the JPY will be a key barometer of the BoJ’s “success” in establishing its relatively more dovish position. And so, preventing unwelcome JPY appreciation from any (mis-)perceived BoJ message may be the low bar for the BoJ.
World Bank’s Worries of Divergent Recovery Too
The World Bank, in its Global Economic Prospects for June 2021, revised 2021 global growth forecast up to 5.6% from -3.5% in 2020; shy of the IMF’s 6%, but solid nonetheless. And clearly, the similarities overwhelm the nuanced differences as like the IMF, the World Bank worries about the divergent global recovery; driven by the uneven progress in vaccinations and attendant re-emergence of COVID-19, alongside policy/financial recourse.
And this unevenness is on full display with growth downgrades for a number of EM Asia economies despite global GDP upgrade.
In that regard, ASEAN-5 (Indonesia, Malaysia, Philippines, Thailand and Vietnam) growth downgrades reflect the long shadow of lingering Covid-19; and lagging vaccine rollout, which are seen to push out a fuller recovery into 2022.
The biggest downward revisions were to Thailand followed by the Philippines and then Malaysia; reflecting degree of tourism dependence and lingering vulnerabilities.
Vietnam’s growth forecast for 2021 was modestly revised down, while Indonesia’s forecast was left unchanged.
Our assessment is broadly in line with the World Bank’s revised forecasts given the lingering Covid impact amplified via tourism channels .
That said, for Indonesia, we are more circumspect, expecting 2021 growth to be sub-4% as the vaccination drive is still progressing slowly and Covid-19 cases (likely under-reported) following the Eid-ul-Fitri holidays has surged.
Notwithstanding, the bottom-line for the region remains that the pandemic will continue to hamper a fuller recovery through most of 2021 before subsiding into 2022; as vaccinations gather pace, allowing growth to pick-up.
Even then, the risks are skewed to the down side especially for Thailand and the Philippines, which are reliant on tourism and tourism related sectors for growth, which in turn is dependent on not just regional but global growth getting back on track in a more uniform manner.
Bank Indonesia: An Uncomfortable Hold
Even as Covid re-emerges in Indonesia following the EId-ul-Fitri holidays threatening to retard and possibly diminish the recovery, emergent macro-stability risks restrain options.
Hence, Bank Indonesia will be forced to remain on hold, albeit uncomfortably so. Notwithstanding the recent stability enjoyed by the IDR, the currency remains vulnerable to sharp sell-offs from global risk sentiment volatility and the potential unwinding of the US Federal Reserve’s ultra-accommodative policy stance.
While “taper” sell-off isn’t imminent (amid expectations for a dovish Fed), Bank Indonesia is nevertheless aware that bottoming inflation corresponding to impending decline in real rate pose a “dove trap” insofar that current decisions to ease will come back to haunt later.
Moreover, ‘twin deficit’ concerns around the widening persistent current account and fiscal deficits – notwithstanding a 15% decline in foreigner holding of Indonesia’s government bonds % since March 2020 – heighten vulnerabilities to capital flow volatility.
Which in turn means that Bank Indonesia’s options are stifled by macro-stability risks.
Admittedly, this effectively rules out headline policy options. But BI is not entirely helpless. Instead, “micro-” credit and liquidity tools may be deployed to help to help grease some parts of the recovery cogs. But this is pain-relief, not panacea.
India’s Inflation Resurgence to Constrains the RBI
Rising oil prices also add to the “stickiness” of consumer inflation and; the attendant policy inconvenience of having to abide by inflation risks despite lingering weaknesses in economic recovery even as India gets past the worst of Covid devastation.
Hence, inflation resurgence, while not a imminent threat to the RBI’s accommodative policy stance, is nonetheless likely to be rendered a persistent constraint on the RBI’s policy .
Credit: Mizuho Bank Ltd
