What to watch for at Jackson Hole

With the August silly season nearly over (Labor Day is less than a fortnight away), the focus of the world’s financial markets this week is squarely on the small Wyoming town of Jackson Hole, where the world’s central bankers are convening for their annual bean feast. No one expects much but there could be a surprise or two in store.

The event always has the potential to shift markets. The clear mountain air seems to embolden naturally cautious and incremental central bankers to signal more seismic policy shifts.

In 2014 Mario Draghi famously stole the show when he used the platform to signal a readiness to carry out quantitative easing in the Eurozone to stimulate inflation, sinking the euro in the process. Ben Bernanke, the previous president of the Federal Reserve, used the event on several occasions to initiate changes in monetary policy, most notably in 2012 when he made a strong case for open-ended asset purchases that would become known as QE3.

So, should forex markets be prepared for a surprise from Jackson Hole this week? So far the runes are not telling us much. ECB sources said not to expect anything major from Draghi. The Fed has already signalled it is prepping for balance sheet reduction.

But this conference comes at a critical moment for central banks, especially the ECB and Fed. After years of accommodation, the dial is shifting, albeit glacially. We’re about to enter uncharted water: unwinding QE has never been done before but it’s about to be tried on markets that have this year exhibited a degree of calm that is worrisome when you consider what may be coming.

Collective action? Beyond the Sintra Pact

The last time central bankers got together was the ECB shindig at Sintra in June. Then there appeared to be a collective hawkish signal coming from central bankers that rattled markets.

The ‘Sintra Pact’ may be a myth, or at least an overstatement, but it’s one that had the markets in its grip and to a certain extent still has. Subtle language changes appeared to show central bankers teeing up financial markets to expect tightening on a wider scale. The ECB and Bank of England were the main culprits.

Mario Draghi suggested inflation is becoming more sustainable and deflationary forces have been replaced by reflationary forces. Importantly he suggested deflationary forces are external, temporary shocks and the ECB can overlook them. That’s what happens when you open the taps on a massive stimulus programme. The question is whether the Eurozone would survive without the QE support. He sounded more circumspect on that front, arguing that he is confident that monetary policy is working but still needs to remain very loose.

Bank of England governor Mark Carney said he would back a rate hike if business investment and wages started to improve. Traders were talking up a rate hike by the Bank of Canada, which materialised in July.

As noted at the time, however, it is stretch to describe the ECB or BoE as delivering a particularly more hawkish bent – Draghi was simply affirming that loose monetary policy is working without significant adverse consequences and therefore should be maintained. He was not advocating tightening any time soon. Neither was Mr Carney.

It looked a lot more like they were signalling that the market needs to be ready for an end to a thirty-year bond bull market. They are posturing for the rollback of QE.

Back to Jackson Hole and the big question this week is whether central banks convey that they are indeed prepping the markets for a gradual shift. If there is this sense of coordinated action again it will provide fuel for bond yields to rise and this could hit equities, although there is yet ample liquidity to support stocks even when the feel-good factor is missing. The question is how long stocks can keep up the pace in the absence of any exuberance and once balance sheet reduction really gets going. The Trump trade looks pretty much dead and buried so investors have to tune into central bankers more closely again.

Asset prices

A key thing to watch in terms of the tone vis-à-vis QE reduction is how central bankers view asset prices. In the chase for inflation, ultra-low and negative rates have inflated asset values and may be leading to heightened risks to financial stability. It rather looks like central bankers are beginning to fret more about imbalances in the financial system than deflation.

Minutes from the Fed’s last meeting noted how “vulnerabilities associated with asset valuation pressures had edged up from notable to elevated, as asset prices remained high or climbed further, risk spreads narrowed, and expected and actual volatility remained muted in a range of financial markets”.

Arguably Sintra marked the beginning of the end for ultra-loose monetary policy. Central banks, so it seemed, are now more worried by financial stability and asset prizes than getting inflation to target. The question for Jackson Hole is whether this sentiment from Sintra is carried forward or whether the lack of inflation is still top of the agenda.

By easing credit conditions after the crisis, loose monetary contributed to improved financial stability. But the longer it goes on the more central bankers see a trade-off between chasing inflation and financial stability. The evidence of the last few months is that the balance is now marginally tilted in favour of ensuring financial stability over hunting that elusive inflation target.

ECB

So we go to specifics, and what to look for from the two big hitters. On the data front, almost nothing has changed so we can’t expect anything radical here. Mario Draghi is likely to further stress that reflationary pressures are in charge and signal confidence about the economy, whilst simultaneously cautioning on the need for monetary policy to remain accommodative.

The elephant in the room for Draghi is tapering. At the last policy meeting press conference Draghi did let slip that the Governing Council is likely to discuss tapering in the autumn. He didn’t say whether the September meeting of the ECB counts as the autumn. Markets will be keen any further details on exactly when discussions may start, and whether the discussion is an immediate precursor to action, or if it’s going to take a lot longer than that. If

Draghi confirms that two years of QE will start to be dialled back soon then we can expect traders to increase their bullish bets on the euro.

However with euro strength a problem, Draghi seems unlikely to stir anything up in the FX markets more than he has already. The minutes from the last ECB meeting revealed policymakers are concerned about the euro’s rapid appreciation. This was noteworthy not just because it could signal a willingness to wait longer before tapering QE, but also because it is an explicit admission (of sorts) at long last that the exchange is a factor in deliberations.

In particular, with regard to the exchange rate, there is the potential for an unscripted remark that could upset the market calm. ECB meetings have fuelled pretty volatile sessions so it would be reasonable to think Draghi’s speech will be similar.

There is also the possibility that Draghi will wish to use the opportunity of the limelight of Jackson Hole to jawbone the euro lower a little by doubling down on the sentiment expressed in the ECB’s last minutes. Expressions of concern about the exchange rate could be used as a counterweight to any other remarks around tapering that the market might take as hawkish. The euro has rallied 5% since May and the appreciation makes achieving its 2% inflation target much harder.

It must be remembered that the ECB does have complete say in tapering – it’s quickly running out eligible bonds and this is forcing its hand to a degree. The ECB is walking a fine line here – it wants to signal that tapering is on the table because it has to keep markets on an even keel, but does not want this to lead to a euro-rally-death-spiral that tightens credit conditions just when as it is forced to tighten. The ECB has to stay ahead of the game.

Fed

Whilst most think the Fed, via Janet Yellen’s speech, will keep its powder dry, this very sanguinity leaves open the possibility of a hawkish/dovish surprise.

There are two key areas to watch. First is on balance sheet reduction. The uncharted territory is close at hand and we can expect Mrs Yellen to offer further guidance here ahead of the September meeting of the FOMC, when markets currently expect the first move to be made. Any hint about timing and pace of reduction will be closely watched.

The Fed’s July meeting minutes provides background. These revealed the FOMC thinks it will be “appropriate to signal that implementation of the program likely would begin relatively soon”. While “several participants” were prepared to announce a starting date for the program last month, most “preferred to defer that decision until an upcoming meeting while accumulating additional information on the economic outlook and developments potentially affecting financial markets”.

Second is the path of the federal funds rate. Minutes from the FOMC’s last meeting showed growing concern about inflation which could deter the Fed from hiking again this year.

Several FOMC members expressed "concern about the recent decline in inflation" and believe that the Fed "could afford to be patient under current circumstances”.

Hawks on the FOMC are worried about risks from a labour market that is project to further tighten. They believe that by backing off from hikes now the Fed risks overshooting on employment and poses a risk financial instability.

Again we can characterise this is a trade-off between inflation and financial stability. Janet Yellen is likely to sound cautious but perhaps could signal a readiness to overlook the softer inflation figures, which the market might take as a relatively hawkish signal.




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