The BoJ met this week and pledged to maintain monetary accommodation, including both targets for short- and long-term interest rates (short-term: -0.1% and long-term: around 0%), and its purchase guideline for JGBs (of increasing its holdings at a pace of about ¥80 tn a year). On the same day the ECB’s Draghi was deliberately vague during his press conference, perhaps being forced by the market into being more dovish to manage expectations he himself had built up in a speech in Sintra a month ago. Earlier this month, Fed Chair Janet Yellen was seen in the same position of being vague after apparently jumping the gun on proclaiming an end to central bank accommodation.

The conundrum facing the central banks is the absence of inflation even as growth picks up. Goods price inflation is particularly weak, in deflationary territory in fact, with headline indices being saved only by services inflation. Improving labour markets, rising PMIs, and higher output all seem to have little impact on inflation. And yet, the Fed and ECB have both signalled, softly or loudly, that it was time to normalize policy. Their motivation must in part be to reset policy normally deployed to fight recessions and financial crises. With inflation so weak, the justification for tightening is thin.

Our read of the central banks is the following:
• The Fed will go ahead with its gradual rate hikes unless the economic data weaken significantly. It will also begin to normalize its balance sheet as soon as it can but do so at a glacial pace. The risk of an overly steep term structure has implications for the funding of corporate America and the state, neither of whom can afford too high a debt service. The yield curve should steepen only gradually.
• The ECB will likely maintain its negative rates but taper its asset purchases. This is not the same as shrinking the balance sheet. To compensate for the withdrawal of demand for bonds, the ECB is likely to step up its LTRO program. The yield curve will steepen, but only gradually, much like the USD term structure.
• The BoJ is likely to do nothing. In addition to QE for the sake of the economy, Japan needs a backstop financier for its mammoth 2.4X GDP worth of national debt, and it needs to keep the term structure fairly flat. The BoJ simply cannot stop buying JGBs. So the short rate stays negative, the 10 year stays at zero, and the long end can steepen a little bit to feed the private commercial banks and insurers.

Given this positioning, we will hazard a rare comment on FX:

EUR. Likely to get stronger.
• 1.15 – 1.40 range was in force when there was no Fed or ECB QE (1990 – 1999)
• 1.20 – 1.40 range was in force when ECB was doing LTRO and Fed was in QE (2011-2013)
• Fed normalizing is positive for USD. ECB normalizing is positive for EUR.
• US cyclical slowdown, a very mild one, vs European cyclical strength is positive for EUR.
• Lateness of ECB normalization relative to Fed may have some surprise support for EUR.

JPY: Likely to be weaker.
• Yen strength 2007 – 2011 was down to Fed QE1, 2, 3. Yen weakness 2012-2015 was due to QE taper.
• Yen weakness 2013 was also QQE. 2014 weakness was the expansion of QQE.
• Fed normalization vs BoJ status quo will be negative for Yen.
• BoJ unlikely to normalize soon.

Week ahead:

Jul 24
• Singapore CPI
• European PMIs
• Taiwan unemployment
• ECB’s Smets speaks
• Existing home sales

Jul 25
• German Ifo
• BoJ minutes, Nakaso speaks
• France INSEE mfg confidence
• US, consumer confidence, Case Shiller House Prices

Jul 26
• UK GDP
• FOMC rate decision
• Singapore IP
• France INSEE consumer confidence
• Italy business and consumer confidence

Jul 27
• South Korea GDP, IP
• Germany consumer sentiment, retail sales
• Eurozone M3
• HK trade data
• US trade balance durable goods, initial claims
• Japan inflation data, retail sales

Jul 28
• France, Spain GDP, CPI, HICP
• Germany CPI, HICP
• BoJ economic forecasts
• Taiwan GDP
• Eurozone business climate, consumer sentiment, economic confidence, industrial sentiment
• UoMichigan
• Fed’s Kashkari speaks