Waiting on BOJ for Price Stability

Macro Perspectives

The Fed raised rates on Wednesday, and announced its quantitative tightening plan to begin on June 1 - the markets responded well. Yesterday, that was not the case…

My view focuses on the chart above of the yield on the 10-year Treasury. This is the benchmark market-determined interest rate, which is the basis for setting many consumer rates.

It spiked yesterday, 16 basis points (a big move), and above 3%. Mortgage rates went to 5.27%, the highest level since 2009.

So, is 3% a dangerous level for rates, given that the Fed has just taken the Fed Funds rate up to 75 basis points? No. The fear is that this move (in rates) is just the beginning of a fast repricing of the interest rate market. After all, the Fed told us that they intend to "expeditiously" take the Fed Funds rate to what they deem to be the "neutral" level (maybe this year), somewhere between 2 and 3%.

If we consider a 2% spread between mortgages and the 10-year ... and a spread of about 2% between the 10-year and the Fed Funds rate ... then the right yield for the 10-year should be in the mid-4% area - that would take mortgage rates to be over 6%.

This begs the question: Why hasn't the bond market already priced this "neutral" Fed rate in? Why isn't the 10-year yield at 4.5% right now? Moreover, if the bond market really is the "smart money," why hasn't the 10-year yield adjusted according to an 8.5% inflation economy (i.e. much, much higher yields)?

Probably because the government bond markets have been highly manipulated by central banks, globally.

The Fed has been explicitly manipulating the bond market, to suppress interest rates, for the better part of the past fourteen years. But now, they are out of that business (allegedly). So, it's logical to think, now that the Fed is out, that the interest rate market could quickly reset to the reality of the inflation environment. That would put the economy at risk of a runaway interest rate market and that would make the Fed's job of price stability and full employment exponentially more difficult.

I suspect that is what created fear in markets yesterday.

But as we discussed over the past few weeks, don't underestimate the appetite of global central banks to coordinate (with the Fed), to keep market U.S. interest rates in check (making the Fed's job to manage inflation expectations and the monetary policy "normalization" easier - and, therefore, the global economic and interest rate environment more stable).  

Not only is the Bank of Japan (BOJ) still in the QE business, but they are in the unlimited QE business (buyers of unlimited Japanese Government Bonds as part of their yield curve control program).  They have a stated policy to buy as much as they see fit.  And in Japan, that also means buying stocks, real estate, corporate bonds - it's all fair game.

From my Fri 29 Apr 22 Note: How do you prevent a global economic shock that may (likely) come from reversing the mass liquidity deluge of the past two years (if not 14 years, post Global Financial Crisis)? You keep the liquidity pumping from a part of the world that has a long-term structural deflation problem, and that has the biggest government debt load in the world (exception, only Venezuela).

The Bank of Japan, in this position, can be buyers of foreign government debt (namely the U.S.) to keep our market rates in check (keeps the world relatively stable), which gives the Fed breathing room on the rate hiking path.

Japan's benefit? The world gives Japan the greenlight to devalue the yen, inflate away debt and increase export competitiveness (through a weaker currency) - they hit the reset button on an unsustainable, debt-laden economy.

My view: It all looks like global central bank coordination. The BOJ decision overnight may have lifted the clouds that have been hovering over markets the past few months. We will see.