Contrasting the ECB with the Fed

November 23, 2009 — Mitul Kotecha

Whether its year end book closing/profit taking and/or renewed doubts about the shape of recovery, asset markets have turned south recently.  Investor mood appears to be souring as risk aversion creeps back into the market psyche.  A string of disappointing US data releases over the last week including core retail sales, Empire manufacturing, industrial production, and housing starts, contributed to the reduced appetite for risk, resulting in a soft finish to the week for equity markets and a firmer USD.

Things are likely to take a turn for the better this week, however. Data will shed a little more light on the pace and magnitude of economic recovery and could result in some improvement in appetite for risk trades.  Despite an expected downward revision to US Q3 GDP, forward looking data on home sales, durable goods orders and personal income and spending as well as consumer confidence are likely to reveal increases.  In the Eurozone, data economic releases will paint a similar picture, including an expected increase in the closely watched barometer of business confidence, the German IFO survey. 

At the least economic data will remove some, but by no means all doubts about a relapse in the recovery process.  There is no doubting the veracity of the recovery in equity and commodity prices, despite doubts about its sustainability. Central banks may not react uniformly to this and the policy impact could vary significantly.  Already it appears that the ECB is moving more quickly towards an exit strategy compared to the Fed.  Although ECB President Trichet highlighted that the crisis is far from over at the end of last week, the Bank announced tougher standards for asset backed securities used as collateral, indicating that the need to provide emergency support to banks is much lower than it was. 

Clearly the ECB wants to avoid letting the market become over dependent on the central bank and will look to implement measures to this aim.  In contrast, the Fed is showing little sign of beginning this process and at least one member of the FOMC, namely St. Louis Fed President Bullard, was quoted over the weekend advocating that the Fed keep its MBS buying programme beyond its scheduled close in March. Evidence of the contrasting stance is also reflected in the fact that the Fed’s balance sheet is expanding once again whilst the ECB’s is contracting.  As a result of firmer data and comments by Bullard the USD is set to go into the week under renewed pressure, albeit within well defined ranges.

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US rates “low for long”

November 19, 2009 — Mitul Kotecha

Risk appetite is failing to show much improvement this week and sharply weaker than forecast US housing data dampened sentiment further following other soft data over recent days including the Empire manufacturing survey, industrial production and retail sales less autos. The data will add to concerns about the pace and magnitude of growth in the months ahead.

A sub-par recovery and benign inflation outlook are the two main reasons why the Fed will not hike rates for a long while yet. This was echoed by St. Louis Fed President Bullard – a voting member of the FOMC – who gave a little more colour on the Fed’s “extended period” statement. He highlighted the probability that US interest rates will not be raised until the first half of 2012.

Bullard noted that following the past two recessions the Fed did not raise rates until two and half to three years after recession ended. This is accurate given that in 2001 the Fed did not begin to hike rates until around 2 ½ years after the end of the recession whilst in 1990-91 rates did not go up until close to 3 years after recession ended. This recession just passed was arguably worse than both of the past two, so why should rates rise any earlier?

One factor that could trigger an earlier rate hike is the risks from the massive global liquidity fuelled carry trade fuelled by Fed policy. Bullard highlighted that the risks of creating an asset bubble from keeping rates “too low for too long” may prompt an earlier tightening. What will be important is that the Fed gets the exit strategy right and the risk that delaying any reduction in the Fed’s balance sheet and asset purchases could turn out to be inflationary which in turn would be negative for the USD and hit confidence in US assets.

The Fed is very likely to adjust the level of quantitative easing well before contemplating raising interest rates. The market is pricing in around 50bps of rate hikes in the next 12 months but even this looks to aggressive and as has been the case of recent months the market is likely to push back the timing of expected rate hikes. The consequences for the USD are negative at least until the market becomes more aggressive in pricing in US interest rate hikes or believes the Fed is serious about its exit strategy.

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Searching for inspiration

November 9, 2009 — Mitul Kotecha

After an eventful week which included several central bank meetings and the US Jobs report there is less for markets to get their teeth into this week.  Despite the weak US jobs report risk appetite looks relatively resilient suggesting that the USD will struggle to make much headway over coming days.  

Despite all of the events last week markets have been uninspired.  Even the G20 meeting delivered little to be excited about with no further developments on how to rebalance the global economy and the USD’s role in the process.  The lack of attention on the USD will leave it with little directional influence this week, with equity markets likely to the main driver once again.

One currency that may look a little better supported over coming days is the EUR.  GDP data later in the week is likely to reveal an expansion over Q3 after several quarters of contraction as indicated by various PMI data. Although it will likely be led by inventories and exports rather than domestic demand it will nonetheless come as good news, albeit backward looking.  Going forward growth in Europe is unlikely to match the pace of recovery in the US but for now the GDP data will be EUR supportive helping EUR/USD to gravitate around 1.50 and beyond. 

Meanwhile, central banks may also do their part in influencing currencies given their differing stances on monetary policy.  Although the Fed did not deliver any big surprises last week the FOMC statement will play for a softer USD as the currency looks to maintain its funding currency status for an “extended period”.   In contrast the RBA hiked rates as expected and despite hinting at more gradual rate increases in the months ahead the AUD continues to stand to benefit.   Going in the opposite direction the BoE increased its asset purchases but GBP avoided a significant negative fall out as the move is likely to be seen as the final step in the BoE’s asset purchase programme.

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US dollar remains funding currency of choice

November 5, 2009 — Mitul Kotecha

Rate hikes in some countries including Australia and Norway and a general improvement in economic data had led to some expectations that the Fed would shift its rhetoric on monetary policy but in the event this was not to be the case.  The key comment in the FOMC statement following the interest rate decision was that rates would be kept low for an “extended period”. The Fed added that its policy stance was contingent on “low rates of resource utilization, subdued inflation trends and stable inflation expectations.”  

The fact that the Fed maintained its relatively dovish stance contrary to some expectations ahead of the FOMC meeting resulted in interest rate markets paring back expectations for future rate hikes though I still believe that a rate hike anytime in 2010 will prove premature.  The Fed’s new conditions mean however, that the Fed will be more restricted when it does come to timing rate hikes and markets will watch closely, the unemployment rate and inflation expectations to determine this timing. 

Given that the unemployment rate is still rising and is expected to decline only slowly over coming months whilst core inflation is set to decline further, and excess slack in the economy is only likely to be reduced gradually, markets are still too aggressive in looking for increases in interest rates next year.  The Fed did not remove the reference to an “extended period” of low rates despite speculation ahead of the meeting and whilst many in the market continue to debate how long this will be, the Fed will not feel any need to rush to reverse policy. 

The USD weakened following the FOMC meeting but did not suffer a particularly hard blow.  Going forward the USD will not recover until there is clearer evidence that the Fed is ready to reverse policy and in the near term this means that the USD will remain under pressure, especially if markets push back expectations of rate hikes.  This will mean that the USD will continue to be the funding currency of choice for several months yet.  Cyclical USD recovery is still some way off but eventually the Fed’s actions will pay off and the USD will recover by around mid 2010 as the market becomes more aggressive in pricing in rate hikes in the US.

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Lots of event risk in the days ahead

November 3, 2009 — Mitul Kotecha

Fears about yet another market crash in October proved unfounded but there were severe bouts of nervousness during parts of the month.  This was hard to tie in with the strength of earnings and continued good news on the economic front but perhaps markets had already priced in a lot of good news.   This was evident in the fact that economic surprises were becoming increasingly negative.

Nervousness is good for the dollar and has at least given the currency a semblance of support.   However, not all the economic news is coming in below forecast as demonstrated by the stronger than consensus reading for the US ISM index for October whilst even the eurozone PMI moved back into expansion territory following 17 months of contraction.

The tone over the rest of the week will depend on the outcome of several central bank meetings the main ones being the Fed, ECB and BoE as well as the US non-farm payrolls report.  None of the central banks are likely to hike rates but in an FX market that is becoming increasingly reactive to interest rate differentials whichever bank sounds relatively more hawkish will see their respective currency strengthen the most.

Unless the Fed sounds particularly dovish the dollar is likely to consolidate further over the short term and given the still significant size of dollar short positioning there is still some scope for some further relief for the dollar.   However, don’t expect much movement out of current ranges until after the payrolls report and even then markets may be hesitant ahead of this weekend’s G20 meeting.

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