Interest rate normalization is back in vogue

Interest rate normalization is back in vogue

The focus for financial markets on Wednesday is central banks. The Bank of Japan announced its latest policy decision early this morning, and they hiked interest rates for the second time this year, raising rates by 15 basis points to 0.25. The BOJ also said that they would cut in half their monthly bond purchases by Q1 2026, to roughly 3 trillion yen per month. The decision to hike rates by a little more than what was expected had been well flagged by the media in the hours leading up to the decision, hence the reaction in the yen and the Japanese 10-year bond yield has been muted. However, Japanese stocks have warmly welcomed this move, the Nikkei and the TOPIX are both up by nearly 1.5%. Japanese banks are the biggest beneficiaries of higher interest rates, the financial sector of the TOPIX is higher by more than 3.5% on Wednesday.

BOJ: inflation rather than growth is the bank’s focus

The BOJ’s commitment to interest rate policy normalization is confirmed. The Bank’s governor also hinted at further interest rate hikes to come, there is currently a 73% chance of another interest rate hike in December, and the market expects Japanese interest rates to end the year at just under 0.4%. In an unusually hawkish move, the BOJ maintained their inflation outlook for the entire forecast period at 2%. This comes even though the economy is showing some signs of slowing down. Thus, the BOJ may prioritize inflation numbers over growth figures when it comes to policy normalization. The BOJ governor said that import price inflation is a cause of concern, in a sign that the BOJ is taking the sharp weakening of the yen in 2024 seriously. Today’s move supports further USD/JPY normalization back to 150.00. This pair has already fallen more than 5% so far this month, and there could be more downside to come as the BOJ supports yen strength to combat inflation, and as the yield differential between the US and Japan is set to narrow further.

The BOJ’s moral hazard problem

The consensus was for a slightly slower pace of bond purchase reduction, however, the BOJ have obviously seen the risks of its QE programme. It now owns more than half of all outstanding short duration JGBs, and a large chunk of longer dated debt. This is unsustainable, a central bank should not own so much of its own debt as it could cause moral hazard.

Policy normalization is the new trend for central banks

The Bank of Japan have embarked on policy normalization and raised rates; however, the question now is, will central banks including the Bank of England and the Federal Reserve join them, but in cutting rates rather than hiking rates? The US and the UK have both experienced prolonged pauses in their central bank monetary policy cycles, with rates remaining elevated for some time. The Federal Reserve will announce their latest policy decision later tonight, the market does not expect a rate cut, however, they do expect the Fed to use this meeting to take a big step towards preparing the market for a series of rate cuts, now that the US labour market is showing signs of strain, and the unemployment rate is rising.

Will the Fed continue to cut rates?

The market has fully priced a cut for September, we expect the Fed to signal that the September rate cut is coming. However, the market is pricing in a 60% chance of a cut in October, a 95% chance of a cut in December and a 71% chance of a cut in January. The market now expects the Fed Funds rate to fall to 4.47% by January 2025. Has the market got carried away? If the Fed maintain their data dependence when it comes to future rate cuts, it could temper some of the market’s enthusiasm for rate cuts, which could push up yields and weigh on value stocks excluding the tech giants.

Beware a less dovish Fed

US blue chip stocks have struggled in July, the Nasdaq is down some 3.3% and the S&P 500 is also down 0.5% so far this month. In contrast, the Dow has soared more than 4% and the Russell 2000 is up nearly 10%. Thus, if the Fed does temper the prospect of rate cuts for later this year, then the smaller and less tech focused US stock market indexes could be hit the hardest. The dollar could also get a boost and the 10-year Treasury yield may see some upside after falling to its lowest level since March.

Bank of England: will they/ won’t they?

The central bank festival continues this week. The Bank of England will meet on Thursday and the prospect of a rate cut is on a knife edge. The market is currently pricing in a 59% chance of a cut at tomorrow’s meeting, which essentially means that the market has a low conviction that a rate cut will happen. In contrast, economists polled by Bloomberg do see a rate cut coming at this meeting and expect rates to fall to 5%. The FTSE 100 has risen more than 2% so far this month, it has underperformed the mid cap and non-tech indices in the US, as the market has embraced the prospect of rate cuts in the US more so than in the UK. Thus, if the BOE does hike rates on Thursday, this would be a ‘shock’ for the market, and we could see UK stock indices bounce and Gilt yields and sterling come under downward pressure. However, there is one factor that could hold back the BOE from cutting rates at this meeting: growth forecasts.  The Bank will announce its latest forecasts for growth and inflation at tomorrow’s meeting, and we expect the BOE to upgrade their growth forecasts, but for its long-term inflation outlook could remain stable. We think it would be unusual for the BOE to cut rates and upgrade their growth forecasts at the same meeting. Thus, this decision for the BOE is too tough to call, in our view, and we expect markets to be volatile around this decision.