Central Banks to the Rescue

This was a busy week for two major central banks, as The Federal Reserve and Bank of Japan maintained their accommodative monetary policies.   As a result, equity markets moved higher, reversing the negative momentum we saw earlier this month.  The Federal Reserve voted to hold interest rates steady despite positive remarks from Janet Yellen regarding the overall state of the U.S. economy.  Consequently, they have yet to raise rates this year after initially calling for 3-4 increases at their meeting last December. Although the committee believes the case to raise rates has strengthened recently due to increased household spending, Yellen stressed that they are waiting to see if progress in the labor market, specifically wage growth, can continue on its upward trend.  After weak economic growth in the first half of the year and inflation still well below their 2% target, they can remain “modestly accommodative” and are comfortable holding rates at current levels.  However, they do expect to raise rates by year end if economy returns to 2-3% expected GDP growth for the second half of the year.

The Bank of Japan expanded their quantitative easing program in an effort to boost economic growth and stoke inflation.  In a change of policy and a break from the Federal Reserve, they are targeting an inflation level above 2%.  Furthermore, they announced an unprecedented move for a major central bank.  They are now targeting a 0% yield on ten-year Japanese government bonds, and will adjust the amount of bonds they buy to achieve this target. This is the first time in the bank’s history that they will attempt to control long term rates.  By combining this with their current negative interest rate policy on commercial bank deposits, they hope to create inflation to pull out of the deflationary environment the country has been in since the 1990s.   Their goal is to steepen the yield curve, which would make it profitable for banks to loan money and in turn, increase economic growth.

It remains to be seen how these policies will impact both economic growth and the market over the long term.  Although the Federal Reserve is encouraged by strengthening economic data, they remain concerned over the lack of business investment and low productivity growth.  This caused them to reduce forecasts for economic growth, inflation and pace of rate increases for 2017 and 2018. Still, 14 of the 17 policymakers on the committee expect rates to rise by 25 bps this year.  With only two meetings left for the year, the expectation is for an increase in rates at their December meeting and not before the presidential election.  We expect an increase in market volatility as we get closer to these events.  Therefore, we have been trimming our equity exposure at market highs to reduce risk and raise cash in our client portfolios. We plan on re-deploying this cash as we see opportunities to invest at more attractive prices.