Liquidity, the Carry & the QT Taper
The dollar wrecking ball, the BOJ & the press conference
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Topic in focus: FOMC press conference, BOJ, liquidity & FX
Alright, let’s get a look at our macro snapshot, thought of the week and chart of the week.
EM Macro FX Snapshot
Given today’s report will be centred around the change and volatility in currency rates I thought it would be important to review the performance of EM FX post-Covid
The impact of higher DM rates, notably Fed rates, on EM FX is equal to that of a wrecking ball swinging into a tower of apartments. Most if not all get crushed, and that’s what we’re seeing here.
Out of a basket of 23 EM currencies, only 5 currencies have managed to 1) hold/maintain their value or (2) gain value against the greenback.
LATAM currencies have faired well in the most recent tightening cycle. As broken down in previous reports, central banks in Latin America collectively hiked policy rates ahead of the Federal Reserve preserving their currency from the large capital outflows they would have faced as rate differentials began to swing in favour of the US Dollar.
With Jay Powell delivering a rather ambiguous outlook for the future rate path, EM currencies are still on the fence as markets have been forced to scale back rate cut expectations prematurely priced in. This creates a dynamic where even though the Fed isn’t expected to hike rates, due to financial markets pricing a dovish/soft landing back in December, markets are having to re-align their rate expectations with the Fed’s maintain and hold stance.
Thought of the Week
“Are financial conditions even tight?”
As we know liquidity is the backbone of financial conditions loosening. So what’s really going on with financial conditions?
Well, as the white line graph tells us, financial conditions are materially loose, we are back to early 2022 levels just before the Fed started hiking which a number of reasons can explain.
Reserves, as we know, are bank liquidity, and despite the Fed’s QT program, reserves have remained ample when looking at Fed liabilities. When observing the RRP balance (Reserve Repo Balance) although we have seen a significant decline from $2tr to $430b, current levels are not flagging up imminent risks.
During the post-Covid era, financial markets have received two huge forms of support that have resulted in financial conditions weakening:
The Bank Term Funding Program (ended in March ‘24), in the wake of the SVB collapse, the Fed valued banks’ securities holdings at par, allowing them to borrow against it for a year. Now it wasn’t only your small banks that took advantage of this, but the larger SIB banks that were beneficiaries of the program.
Fiscal largess: let's address the elephant in the room: the Biden Administration's spending packages (IRA, CHIPS Act, Infrastructure Act) have demonstrably influenced business risk tolerance and investment decisions, fueling economic activity.
These factors have added up to subdue financial conditions in the U.S effectively promoting an environment for more risk-taking.
Chart of the Week
The Carry Persists
The Yen has been under close observation by all FX & rate traders. The BOJ responded with an intervention, authorised by Masato Kanda, the top currency official at the Ministry of Finance (MOF). This was subsequently followed by a further intervention by the BOJ, likely aimed at capitalising on a dovish stance during the press conference.
The chart of the week coincides with the main report, so I’ll save the details for the main section.
Too Good To Give Up - Carry
“Did they, or did they not?”
That was the question most of the market was asking on the Monday opening of trading after the Dollar-Yen traded down 1.50%. The Yen has largely been a point of discussion, concerns of further weakening in the exchange grew louder as the Yen traded to a 34-year low sparking a flurry of discussions within financial media about when the MOF would intervene to stabilise their currency.
We can now put to bed the doubt about whether it was or wasn’t currency intervention from Japan.
Figure 4 shows the assets of the BOJ, and the bar column graph below shows the daily change in assets. As we can see the circle to the far right shows a large 1-day decline in BOJ assets which confirms the intervention by the BOJ to back-stop its currency slide. Looking at the larger highlighted region within 2022, we can the two interventions of 2022, September & October.
Estimates suggest that the Bank of Japan's (BOJ) interventions on Monday, April 29th and Wednesday, May 1st, amounted to ¥3.5 trillion (approximately $23.6bn). While this represents a relatively modest expenditure within the context of the BOJ's vast asset holdings, FX intervention is a costly endeavour for any central bank. Moreover, its effectiveness in achieving a lasting stabilization of the yen appears limited given the market’s reaction.
Japan can’t buy its way out of a weak Yen, and the events this week confirmed that. Immediately after the first intervention traders sold more Yen as they bet on Dollar Yen rates returning to 157.00, which is subsequently did.
The BOJ’s recent interventions in the FX market show their strategic approach. Notice how the BOJ has been actively buying Yen during periods of low volume in the market. Monday’s intervention came during a public holiday in Japan around 05:00 am GMT/ 1:00 pm JST. Similarly, the subsequent intervention took place immediately following a dovish press conference by Federal Reserve Chair Jerome Powell, again during a period of historically low trading volume, coinciding with the US market close (between 9:00 PM and 10:00 PM GMT).
What can we infer?
The BOJ trading illiquid hours and intervening twice in one week to support their currency may not be a monumental thing, but it signifies the lack of confidence in their efforts to have long-lasting effects on the Yen.
The message here is simple, the carry trade is too good for traders to give up, and each sell-off in USD/JPY will be viewed as an opportunity to buy the dip.
Figure 5 sums up the reasons why FX intervention isn’t enough. Yield differentials are causing the persistent devaluation of the Yen. The differential between the UST curve (green) and the JPY Curve is c.3.7% on the 10y maturity. At the front end of the curve, the differential is even greater + 5%. This is exactly why the Yen can’t be saved by large Yen purchases and sales of Dollars— to really move the positioning of the market the BOJ would have to hike policy rates and or allow 10-year JGB rates to rise above the 1.00% upper bound.
Beyond traditional monetary policy considerations, several factors currently limit the BOJ’s ability to raise interest rates. The most prominent of these is Japan's significant national debt burden. While it's true that the BOJ holds a large portion of Japanese Government Bonds (JGBs), c.53%, the government remains responsible for servicing this debt. Higher interest rates would translate to a substantial increase in the government's fiscal spending on debt payments, potentially straining its budgetary resources
The subsequent set of issues that follow would all result in higher rates on JGBs piling the pressure on the Japanese government to manage its growing $9tr debt burden.
This brings us perfectly into our roundup review of the FOMC press conference.
Cue The Taper
The Wednesday FOMC meeting surprised both Main Street expectations and financial markets. In the early moments of Jay’s press conference, equities caught a bid, rallying for the first hour mostly due to Jay’s confirmation that “it's unlikely that the next policy rate move will be a hike”.
The most notable takeaway from the press conference is that Jay Powell’s focus remains squarely on inflation, and he doesn’t see a tapering of the Fed’s balance sheet as a risk to inflation or financial conditions from easing further, but rather as a safety mechanism to prevent “money markets experience stress”.
The Fed confirmed the long-expected QT taper, which would begin as early as June 1st, slowing the pace of decline in securities holdings from $60 billion per month to $25 billion per month.
The expected taper amount would have slowed the roll-off to $30 billion per month, the actual figure surprised most forecasters whilst sparking concerns that this is contradictory to the Fed’s policy stance. While a slower taper provides ample liquidity for banks, historically, such easy financial conditions tend to loosen credit and potentially counteract the Fed's inflation-fighting goals.
It’s clear the Fed are optimistic about the disinflationary regime continuing as Jay pointed to an easing labour market further presenting an environment for lower inflation as we see “demand cooling” as “quits and hirings” begin to normalise from pandemic highs.
The most important thing remains— when is the cut?
Let’s break down what we see above.
First and foremost, the market continues to only see one rate cut in 2024. Take a look at the #Hikes/Cuts column, this tells us the number of hikes/cuts expected and implied by the market.
The Imp. Rate ∆ simply tells us, what change in overnight rates ( fed funds) the market is expecting based on market pricing for each meeting.
From the implied overnight rate curve, we can see the market is only pricing in one cut coming in November, (one day after the Presidential election). This changes little for asset markets, the overwhelming consensus for rate cuts had already been pushed back to the end of the year. This isn't a significant shift for asset markets, as the dominant expectation for rate cuts had already been postponed to year-end. However, if inflation persists at elevated levels, I expect markets to completely abandon the notion of rate cuts. In essence, this would be a dramatic reversal from December's expectations, effectively being a rate hike in disguise.
For now, my focus remains where the Fed is, inflation, inflation inflation—not to mention the labour market.
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Enjoyed this read. with the BoJ can a case can be made that they are trying to operate all sides of policy trilemma, can either agree to prioritise monetary policy autonomy which would lead to more devaluation or focus on maintaining ER stability (hike along side the fed)?
It’ll be interesting to see how the PBoC reacts to a weaker Yen while shedding of their $ reserves. Any thoughts on this?