For Once, the Fed Is Showing It's Smarter Than the Markets

by Enda Curran, Chris Anstey, Jeff Black, and Matthew Boesler

March 17, 2017, 7:20 AM CDT

The shoe is on the other foot.

That’s the takeaway from the past three weeks, which have shown the Federal Reserveregaining command of the outlook for U.S. monetary policy. Traders have moved more into step with Fed officials’ dot-plot chart for projected interest-rate increases -- a big contrast from last year, when the market called the central bank out on its plans for four rate hikes.

It’s not just the Fed that seems in greater command of the policy outlook in 2017 than has been the case for some years. The People’s Bank of China, on occasion has had to drive up market rates to squeeze out yuan speculators, and which flubbed its tinkering with currency policy in 2015, now is taking a surgical approach with incremental policy steps such as this week’s tightening of some money market rates.

Behind this shift toward central bankers directing markets on the policy agenda is a strengthening in the global economic outlook that’s giving officials room to maneuver. It’s a big change from 2015 and 2016, when deflationary fears left investors skittish and market volatility appeared to often dictate central bankers’ actions.

"A year ago, there was a feeling around that central banks had lost a bit of control," said Shane Oliver, head of investment strategy at AMP Capital Investors in Sydney. "Now it’s clear that they are firmly in control -- growth has firmed globally and the risks of deflation have receded."

The difference can be most clearly seen with the Fed, which began 2016 with an expectation to raise its benchmark four times. Futures traders gave that outcome just 14 percent odds, and proved right to do so -- in the end, there was only the one quarter-point move. This year began with the market again disbelieving the Fed and its outlook for three hikes, placing minority odds on that many moves. Now, the probability is around 57 percent.

What changed? The key was a slew of top Fed policy makers, culminating with Chair Janet Yellen, flagging the likelihood of a previously unexpected March increase. Vice Chair Stanley Fischer effectively acknowledged the coordinated messaging, saying March 3 that if there was a "conscious effort" to boost rate expectations, "I’m about to join it."

The Fed’s hand can also be seen in the contained rise in longer-term Treasury yields. Policy makers have anchored them through consistent communication that the so-called equilibrium for the benchmark interest rate is lower than it once was, around 3 percent.

"The latest market reactions to the FOMC decision seems to suggest that there is a great deal of credibility in the r* being low," said Stephen Jen, the London-based chief executive of hedge fund Eurizon SLJ Capital Ltd., using the economics term for equilibrium interest rate.

In China, the PBOC has helped manage a shift in sentiment towards the world’s No. 2 economy, with a little aid from stringent capital controls that have curbed an exodus of funds abroad and eased pressure on the yuan. Starting in late 2016, officials moved steadily to raise money-market rates, helping to scale back leveraged bets and support the currency. At the same time, they have left benchmark lending rates unchanged to aid growth, and taken pains not to spook markets that an all-out tightening cycle is under way.

"They’re pretty clear in their own minds that there are enough potential surprises coming at them that they don’t want to be over-committed on forward guidance," Nobel laureate Michael Spence, a professor at New York University’s Stern School of Business, said Friday in a Bloomberg Television interview in Beijing.

To be sure, the confidence isn’t universal. The European Central Bank, navigating a complex political and economic reality as it seeks to manage a 19-nation currency zone, is way behind what the market thinks. That’s partly because it’s just gingerly beginning to signal a change from almost a decade of mostly easing policy to potentially an era of tightening.

At its policy meeting on March 9, the ECB kept rates and its stimulus settings unchanged. Yet even a minute tweak in President Mario Draghi’s language sent the euro soaring and measures of future borrowing costs rising. Policy makers have since rowed back, arguing that the economy is still fragile and dependent on monetary support. 

In Japan, the central bank went from leading markets in 2013 to unnerving them in 2016 with a shock negative-rate policy, and is now in something of a stalemate. Fluctuations in 10-year government bond yields last month spurred officials to ramp up purchases. Governor Haruhiko Kuroda for now has stared down market speculation that he’ll need to raise the yield-curve target if global bonds sell off, but has yet to face a full-on test.

For the Fed, markets could still head back into the driving seat, Jen said -- especially if inflation picks up in a way that the Fed doesn’t anticipate, sending longer-term yields higher and forcing the Fed to react.

"The trajectories all look quite smooth and pretty in the Fed’s table, but in reality things will likely get messier," Jen said.

For now at least, the mood music is shifting the way of central banks as policy makers adapt to the improving world economy. That offers officials a respite to work on the next big challenge: whether and how to shrink their gargantuan balance sheets.

"Central banks are in a much, much better place," said Klaus Baader, chief Asia-Pacific economist at Societe Generale SA in Hong Kong.  "At the same time financial market reaction has been very tame and until now has not disturbed a gradual normalization of policy."

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