Weekly Commentary – July 24, 2017

CENTRAL BANK MANIA CONTINUES

Shawn Doty Senior Analyst, LPL Financial

Matthew E. Peterson Chief Wealth Strategist, LPL Financial

The conclusion of the Federal Reserve’s (Fed) meeting on July 26 will end a busy seven days for central bank watchers that also saw meetings for two other major central banks — the Bank of Japan (BOJ) and the European Central Bank (ECB). The Fed’s policy meeting will end with a prepared statement, but will not feature any new economic projections or a press conference. The excitement seen at the Fed’s last meeting in mid-June, which included a rate hike and additional details regarding balance sheet normalization (see blog from June 14), is unlikely to be repeated, with markets pricing in only a 3% chance of a rate hike the start date for balance sheet normalization and the future path of rate hikes.at this meeting. However, markets will closely read the Fed’s statement for any hint of the start date for balance sheet normalization and the future path of rate hikes.

BOJ AND ECB TAKEAWAYS

The BOJ and ECB both met last week, though neither offered much in the way of surprises. The BOJ left its policies unchanged, keeping its policy rate at -0.1% and continuing to target the 10-year Japanese Government Bond around 0%. The BOJ did raise its assessment of the Japanese economy slightly, but lowered its inflation forecasts. It now expects inflation to reach its 2% target in its 2019 fiscal year (FY), which runs from April 1, 2019 to March 31, 2020. It previously had expected the 2% target to be reached in FY 2018.

Prior to the ECB meeting, Mario Draghi had given a speech in Sintra, Portugal on June 26, 2017 that markets interpreted as leaning hawkish, leading to a move higher in both foreign and domestic rates. While the speech wasn’t that different from Draghi’s previous statements (see blog from June 30), markets keyed in on a few points about the recovery in the European economy and the potential for an eventual end to the ECB’s negative interest rate and quantitative easing (QE) polices. Following these comments, markets were watching last week’s ECB meeting closely for any changes to the bank’s outlook and for any hint of further tapering of QE.

The ECB’s policy statement was basically status quo, though it did maintain a dovish tilt regarding inflation, indicating that “measures of underlying inflation remain overall at subdued levels,” and that, “a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to gradually build up and support headline inflation developments in the medium term.”

During the Q&A session, Draghi indicated that the council was “unanimous in setting no precise date for when to discuss changes in the future” pace of its QE purchases. Markets, however, continue to expect a potential announcement regarding a further tapering of QE in either September or October. Interestingly, even though the ECB’s statement was basically status quo, markets don’t appear to be buying the ECB’s message, as the euro has headed higher to hit its strongest level versus the dollar since January 2015 [Figure 1].

FED PREVIEW

The July meeting of the Federal Open Market Committee (FOMC), the policy arm of the Fed, will take place this Tuesday and Wednesday, July 25 – 26. After raising rates in June for the fourth time this cycle, market expectations for a rate hike are very low, near 3% currently. Though the projections from the June Fed meeting showed a median expectation of one additional rate hike by the end of 2017, markets are less certain, pricing in slightly less than a 50% chance of a rate hike by the Fed’s December meeting [Figure 2].

The Fed released details about its balance sheet normalization plan at its June meeting, but one major question that remains unanswered is the start date. Markets currently expect that the Fed will wait until at least its September meeting to begin implementation of the plan, but official statements from the Fed have been vaguer, hinting at start dates ranging from September to December 2017. Though markets are eagerly awaiting a start date, the immediate impact of normalization is likely to be limited given that it will start with allowing just $10 billion ($6 billion of Treasuries and $4 billion of mortgage-backed securities [MBS]) of maturing bonds to roll off the $4.5 trillion balance sheet each month.

The Fed’s current plan is to increase this number by $10 billion every three months, until it reaches a maximum of $50 billion per month ($30 billion of Treasuries and $20 billion of MBS). This pace will then continue until the balance sheet reaches a size the Fed is comfortable with. The Fed has said that this number will likely be larger than the pre-crisis level of roughly $900 billion, but an exact figure has not been provided.

Overall, it appears that the July meeting may elicit little response from markets. The policy statement will not be accompanied by updated economic projections or rate expectations, and market participants will have to parse the brief policy statement itself, released at 2 p.m. ET on July 26, to gain any further insight on the Fed’s intentions. Markets will continue to watch the statement closely for any signs of change, especially to the Fed’s view of inflation, which was downgraded at the June meeting.

Following the July meeting, the next major Fed meeting, which will include economic projections and a press conference, will take place September 19 – 20. However, markets will have plenty of Fed speak to digest before then, with the minutes of the July meeting expected on August 16, and the Fed’s annual Jackson Hole Symposium taking place August 24 – 26.

CONCLUSION

The fact that three major central banks met in the seven days between July 19 and July 26 makes for a lot of headlines and speculation in a short period of time. However, after relatively benign statements from the BOJ and ECB last week, and low expectations for any changes at the Fed’s meeting later this week, the actual impact to markets may end up falling flat.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

Any economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

International debt securities involve special additional risks. These risks include, but are not limited to, currency risk, geopolitical and regulatory risk, and risk associated with varying settlement standards. These risks are often heightened for investments in emerging markets.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.

Quantitative easing (QE) is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve Board that determines the direction of monetary policy. The eleven-person FOMC is composed of the seven-member board of governors, and the five Federal Reserve Bank presidents.

The European Central Bank (ECB) is the central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed in Germany in June 1998 and works with the other national banks of each of the EU members to formulate monetary policy for the European Union.

This research material has been prepared by LPL Financial LLC.

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