US Federal Reserve Chair Janet Yellen's speech did not give many surprises last Friday. She did not indicate when the U.S central bank might raise rates, but her comments reinforced the view that such a move could come later this year.
Janet Yellen devoted much of her speech to outlining how the Fed may deal with future recessions over the long term. She also mentioned US interest rates would likely be lower on average due to slower growth. The Fed can use bond purchases and forward guidance to ease conditions. Such a view is exaggerated. Market gradually believes that monetary policies become more and more unconventional.
For investors, they should learn the lessons from the Fed because ECB and BOJ also face the same situation. But their processes lag behind the Fed. Until today, ECB and BOJ schedule to end QE in 2018, three and a half years behind Fed. Since Fed began “taper tantrum” in 2013, it is time for investors to discuss how ECB and BOJ exit from unconventional monetary policies.
1. Avoid policy reversals
US's monetary policy is gradual and slow in the past three years. Central banks avoid policy reversals. Not only do policy reversals create turbulences in financial markets, but also damage central bank credibility which makes it more difficult to implement monetary policy in the future. The latest example is ECB. The ECB increased its policy rate 50bps in 2011, only to reverse course quickly thereafter. BOJ also had premature tightening period in the past 15 years.
The cautious actions of central banks will lead to lower interest rate environments and higher average valuation of financial assets. However, any implication of policy move will hurt market sentiment. Investor will likely face one-time shock in the low volatility environment in future.
2. Consider currency connection
Monetary policy can connect between two economies with floating exchange rate regime. For example, US and Euro area are linked through a floating exchange rate. Opening capital accounts means money can leave the market and affect nominal exchange rate. As a result, attempts by the Fed to increase interest rate lead to a hike in USD but fall in Euro.
Global connection provides investment opportunities and risks for investors. In the past three years, USD-dominated investors can also benefit from USD appreciation. But JPY-dominated investors face a roller coaster situation.
USD/JPY (Black) and USD index (Yellow)