Shifting Rate Expectation

What began off last week as a correction to the dollar's surge in the first days of the new year morphed into something much more last week and has continued into this week's activity. There has been a profound shift in interest rate expectations. Seemingly hawkish comments from ECB President Trichet as December euro zone CPI was confirmed at 2.2% put the proverbial cat among the pigeon. Meanwhile in the UK, anecdotal evidence warned of the stubbornness of UK price pressures and there was more speculation of a hike later this year. Today's stronger than expected CPI data (3.7% vs 2.% in November and consensus expectation of 3.4%) drives home that point.

At the same time this market has gotten a bee in its bonnet about Euopean rate hikes, the recent string of data and official comments suggest that 1) US growth in Q4 was somewhat less than had been expected and 2) the Federal Reserve will continue it s unconventional easing of monetary policy via Treasury purchases. Recall that $100 bln in US Treasury purchases is roughly equivalent to 10-15 bp of easing. While the market is pricing in European tightening, the the market is shifting expectations for the first Fed hike deeper into 2012. This combination of factors is providing the fuel for the dollar's slump.

There are different ways to measure the shift in expectations. Our work has emphasized short-term interest rate differentials, captured in the 2-year sovereign interest rate differential. Consider that the 2-year US-German spread has nearly tripled to 60 bp in Germany favor form 20 bp as recently as January 5. The spread stands at its widest since late November.

Last year, cable seemed even more sensitive to US-UK 2-year spread moves. Today the spread is just below 80 bp, the widest in a year. A rate hike from the central bank that hiked rates in July 2008 near the epicenter of the worst financial crisis in a generation cannot be ruled out entirely, but clearly the risk is that the market is getting ahead of itself if it is indeed pricing in 100% confidence of a hike in the first half of this year. UK inflation has been more resilient than policy makers and market participants expected.

The market appears to be more aggressive than policy makers. The BOE's Fisher who some have identified as a likely candidate to join the dissenting hawk Sentance, but his comments suggest that although the short-run inflation figures are discomforting that policy makers needs to look toward the medium term drivers. This has been echoed by the UK Treasury that recognizes the heightened inflation impacts, including last January's VAT. The risk is that inflation pressures build further in the next couple of reports as this year's VAT takes hold (and more). The BOE's quarterly inflation report on 16 Feb will be critical in shaping market expectations.

In addition to the shift in interest rate expectations, there is speculation that European officials will "soon" announce what has been called a "comprehensive" solution to the debt crisis. Hopes that it would happen sooner rather than later have been setback a bit, but have not been derailed. German officials seem to be balking at increasing the size of the EFSF and with seven state elections, beginning next month, German domestic politics serves as a constraint on the country's foreign economic policy.

However, because of the gap between the size of the guarantees and the amount the EFSF can actually loan and maintain its triple A status, German officials seem keen on making the EFSF more efficient. There is some talk of lowering the interest rate on aid packages, but we argue that in past debt crisis, lowering the debt servicing costs has proven insufficient and one way or another the principle has to be reduced. It is our understanding that the IMF and many in the euro zone wanted to charge Ireland a lower rates, but German insisted otherwise. There is also some talk that the EFSF could take over bond buying from the ECB. It is clear that EFSF bonds, like the EFSM last week, will be in high demand.

The market seems confused. These bonds attract strong interest. There is simply a shortage of triple-A European sovereign paper relative to demand. Shifting owners of European debt, from weak private hands that must mark-to-market in some fashion, to the ECB, EFSF, or even foreign central banks does not change the debt dynamics nor addresses the lack of competitiveness on the periphery and hence we remains skeptical that the end game is at hand.