Fed Chair Powell’s speech at Jackson Hole continued to reverberate around markets on Friday, driving a big fall in the USD to a fresh two-year low and pushing equities and inflation expectations higher again. US Treasury yields reversed some of their sharp rises from the previous session, albeit with further steepening out to the long-end of the curve. The weaker USD catapulted the NZD to its highest close in more than a year and the AUD to its highest level since late 2018. Assistant Governor Hawkesby told Bloomberg that the RBNZ was thinking the same way as the Fed and would likely embrace a period of inflation above 2%.
The market continues to digest Fed Chair Powell’s speech from Thursday night. To briefly recap, Powell confirmed that the Fed would adopt an ‘average inflation targeting’ framework, whereby it would aim for inflation above 2% to compensate for previous periods where it undershot the target. The Fed also signalled that it would run the labour market ‘hot’ (i.e. the Fed wouldn’t tighten rates pre-emptively if unemployment was at very low levels, unless this was translating through to higher inflation). The initial market reaction to Powell’s speech was higher equity markets, higher long-end US Treasury yields (i.e. a steeper curve) and higher market-based inflation expectations.
The USD didn’t move much in the immediate aftermath of Powell but it played catch-up on Friday night. There was a broad-based weakening in the USD, ranging from a 1.6% fall against the NZD to a 0.2% fall against the CAD. The Bloomberg USD index fell 0.9%, its biggest one-day fall since May and taking it to a fresh two-year low. The Fed’s commitment to achieving higher inflation, to the extent it is credible, should be a downward force for the USD by lowering US real interest rates.
The NZD made a new high for 2020, rising by 1.6% to around 0.6740. On a closing basis, this is the highest level for the NZD in over a year. Over the week, the NZD gained more than 3%, outperforming all the other G10 currencies, and highlighting that global forces, rather than RBNZ policy, will likely remain the key influences on the NZD/USD going forward. The AUD rose 1.5% on Friday and 2.9% on the week, taking it to its highest level since late 2018. The risk-on tone to markets and broader USD weakness also saw sharp gains in high beta emerging market currencies, with the Brazilian real up more than 3% on Friday and the South African rand 2.6% higher. The EUR closed the week back above 1.19 although it faces stiff resistance at 1.20.
US equity markets extended their gains from Thursday, with the three key US benchmark indices rising around 0.6%. The Dow Jones made a high for 2020 while the S&P500 and NASDAQ both closed at record highs. Commodity prices strengthened also, with copper making a two year high, suggestive of growing economic optimism.
European equity markets, in contrast, were modestly lower on Friday and the Nikkei fell 1.4%, with the latter impacted by the unexpected resignation of PM Abe for health reasons. The JPY also strengthened on Friday (+1.15%), with the Abe resignation briefly causing the market to question whether this might affect the BoJ’s very easy monetary policy stance (although Governor Kuroda’s term is not due to end until 2023).
Yield curve steepening remains the key theme in global bond markets. Two to five-year Treasury yields fell 3 to 5bps, consistent with the Fed’s lower-for-even-longer pledge. In contrast, the 30-year Treasury yield was unchanged, at 1.50%. The gap between 5-year and 30-year Treasury yields reached its highest level since late 2016, at 123bps. A steeper yield curve is consistent with the market pricing in greater inflation risk premia into the long-end of the curve (a sign that the Fed’s strategy is perceived as credible by the market) and an eventual normalisation in its policy rate (which would be a sign of success for the strategy). The 10-year rate was 3bps lower on Friday, to 0.72%, but that still left it 10bps higher on week and at its highest level since June.
Market-based inflation expectations continue to head higher. The US 10-year ‘breakeven inflation rate’ rose another 3bps on Friday to 1.78%. Expectations of US inflation 5-years’ ahead (the so-called 5-year 5-year forward inflation rate), derived from swap markets, rose to 2.13%, the highest level since mid-2019. It remains to be seen how far inflation expectations can climb without tangible evidence of rising inflationary pressure in the data. Philadelphia Fed President Harker told CNBC he would be comfortable with inflation “somewhere north of 2%.” Harker added “it’s not so much the number, whether it’s 2.5% or 3%”, but rather the speed with which inflation is rising which could prompt Fed to tightening policy.
Bringing things back to New Zealand, Bloomberg reported Assistant Governor Hawkesby as saying that the RBNZ also saw scope to let inflation “spend some time above the mid-point of the target range in the future”, following an inflation undershoot. Hawkesby’s comments reinforce the lower-for-longer narrative for NZ rates. Whether that extends to an even longer period of negative interest rates, if the RBNZ does indeed go down this route next year, is unclear. Overseas central banks which have experimented with negative rates, including the ECB and the Riksbank, have previously expressed concern that the detrimental side-effects of negative rates could become more pronounced if they were expected to remain in place for a very long time. Just like with the Fed, we should expect to hear more in the future about how the RBNZ is interpreting its inflation target.
There was a big steepening in the NZ curve on Friday and a rise in breakeven inflation (to a still-low 1.08%), reflecting global forces. The 2-year swap rate was unchanged, but the 5-year rate lifted 4bps, to 0.21%, and the 10-year rate by 7bps, to 0.63%. The RBNZ has consistently reiterated its desire for a flatter curve, but we would see a steeper curve, provided it is driven by reflationary expectations, as an endorsement from the market that monetary policy will be effective.
Separately, the RBNZ kept its bond buying for this week unchanged at $1.35b in government bonds ($1.25b nominal bonds and $100m in inflation-indexed bonds) and $50m in local government bonds. The RBNZ’s bond buying this week is greater than the amount of issuance from NZDM ($950m) as it continues to ‘frontload’ purchases. There was no reaction to the announcement, with the market focused on the big sell-off in global bonds.
In other news, BoE Governor Bailey reiterated that negative interest rates remain “in the toolbox”, alongside other unconventional policies, although the market was unmoved by his Jackson Hole speech. Economic data were largely overlooked by markets. The was a small upside surprise to the core PCE deflator, the Fed’s preferred inflation measure, but, at 1.3%, it remains well below 2%, let alone the 2.5% to 3% levels mentioned by Harker.
Influential Fed Vice Chair Clarida speaks tonight and the market will be closely attuned to any comments on how the Fed might operationalise its new framework. The ISM surveys are released this week and US nonfarm payrolls is on Friday night (+1.4m jobs expected, 9.8% unemployment rate). Locally, the final version of the ANZ business survey is released today and should show some further weakness post the re-emergence of COVID-19 community transmission in New Zealand and resulting lockdown in Auckland.