Markets in 3 Minutes: Markets Dovishly Await Fed Amid Hassett

Key Concepts

• Bank of Japan (BOJ) Monetary Policy: Expected interest rate hike, its implications for JGB yields, and factors making JGBs unattractive.
• Federal Reserve (Fed) Monetary Policy: Market pricing for rate cuts, potential for hawkish surprises, and the significance of new projections and dots.
• Duration Mismatch: A key concern for the Japanese economy impacting fiscal capacity and the ceiling for policy rates.
• Personal Consumption Expenditures (PCE) Price Index: Market expectations and the likelihood of it being overlooked due to dovish pricing shifts.
• VIX (Volatility Index): Mentioned as a potential indicator of market surprise.

Bank of Japan (BOJ) Policy and JGB Yields

The discussion begins with an anticipated interest rate hike by the Bank of Japan (BOJ) on December 18th-19th, contingent on no major unforeseen events occurring. This policy shift is expected to lead to an upside for Japanese Government Bond (JGB) yields. Several factors contribute to JGBs being considered relatively unattractive within the broader government bond market:

• Duration Mismatch: A significant duration mismatch exists within Japan. As policy rates rise, there's a concern that fiscal capacity could deteriorate more rapidly compared to other developed markets. This mismatch also imposes a lower ceiling on where the policy rate can ultimately go, making it lower than in other countries.
• Unattractive Yield: Due to the aforementioned duration mismatch and other factors, JGBs are perceived to offer a relatively unattractive yield.
• Fiscal Policy: Anticipated fiscal stimulus is expected to lead to higher growth, which is negative for bond prices.
• Increased Issuance and BOJ Holdings Reduction: Higher issuance of government debt, coupled with the Bank of Japan reducing its holdings of these bonds, further contributes to their unattractiveness.

The BOJ is noted for telegraphing its policy intentions, similar to the Federal Reserve's approach of providing advance signals.

Federal Reserve (Fed) Policy and Market Expectations

The conversation then pivots to the Federal Reserve (Fed), with a focus on market expectations for potential interest rate cuts.

• Dovish Pricing: Market pricing has become significantly dovish in recent weeks, with a 25 basis point rate cut next week being largely priced in.
• Potential for Hawkish Surprises: Several factors could lead to hawkish surprises from the Fed:
  • Kevin Hassett as Fed Chair: Rising bets on Kevin Hassett becoming the next Fed chair could signal a more hawkish stance.
  • Terminal Rate at 3%: A terminal rate of 3% is considered difficult to go lower than without significant economic deterioration, suggesting limited room for further dovish adjustments.
  • New Projections and Dots: The upcoming meeting will feature new "dots" (individual policymakers' projections for interest rates) and economic projections. These, along with commentary from the new Fed chair, will be crucial.
• Divided Federal Reserve: There's an observation that the Fed is becoming more divided, and the Fed chair may no longer represent a unified consensus.
• Comparison with BOJ: The Fed is considered to provide a bigger potential surprise than the BOJ due to its greater spillovers to global markets and the current dovish pricing.

US PCE Price Index and Market Reaction

The US Personal Consumption Expenditures (PCE) price index is discussed, with the expectation that it will be largely ignored by the market.

• Delayed Data: The PCE data is described as "very delayed."
• Dovish Pricing: The market has already shifted its pricing in a dovish direction, making it difficult for the PCE number to cause a hawkish surprise.
• High Bar for Surprise: Expectations are for core PCE to come in close to 3%, which sets a high bar for the data to surprise hawkishly.
• Limited Dovish Room: As mentioned earlier, there isn't much room for the Fed to surprise on the dovish side.
• Focus on Fed Commentary: The primary focus for potential hawkish shifts is expected to be on the Fed's meeting next week and its accompanying commentary.

Conclusion and Key Takeaways

The discussion highlights that while the Bank of Japan is poised for a rate hike, making JGBs less attractive due to structural issues like duration mismatch and fiscal concerns, the Federal Reserve presents a greater potential for market surprise. The market has priced in significant dovishness from the Fed, particularly regarding rate cuts. Therefore, any hawkish signals from the Fed's upcoming meeting, especially through new projections, dots, and commentary, are likely to be the most significant market-moving events. The US PCE data is expected to be a non-event due to prior dovish pricing. The overall sentiment suggests a cautious watch on the Fed for potential shifts in monetary policy direction.