Central Banks Dominate Forces of Movement in the Week Ahead

The most important force that has lifted the US dollar across the board is the sense, encouraged by official comments, of the potential divergence in the trajectory of monetary policy between the US and most of the other major high income countries. 

In particular, the pendulum of market psychology has swung back toward speculation of tapering off of QE-related asset purchases by the Federal Reserve.  At the same time, ECB officials continue to indicate they are carefully considering a negative deposit rate. Many still expect the Bank of England to resume its gilt purchases program and new initiatives on its forward guidance in Q3 after Carney takes the helm. 

Meanwhile, Carney and the Bank of Canada continue to push further out when they anticipate full capacity will be reached and when it will remove some accommodation by increasing interest rates. The recent string of economic data, including prices, has been generally softer than expected and the forward guidance the central bank has offered is becoming less credible. Additional easing by the Reserve Bank of Australia is expected, though the recent sharp drop in the Australian dollar appears to be tempering expectations of a rate cut as early as next month.

Japan’s quantitative and qualitative easing is not even two months old. It is far too early to suggest a reassessment, though Q4 12 GDP was revised up and Q1 13 GDP came in stronger than expected and may be revised after Japan releases the latest capex figures in early June. Capital investment was an unexpected drag on Q1 GDP and may be adjusted higher.

Although there are several important pieces of economic data in the days ahead, including UK inflation and retail sales reports, euro area flash PMI readings, German IFO, Japan’s latest trade figures, US durable goods orders, the focus is on the central banks.

The Fed’s Dudley and Bollard speak on Tuesday, but the real interest is on Bernanke’s testimony on the economic outlook on Wednesday. Comments by regional Fed presidents who do not vote this year on the FOMC has helped fan speculation of tapering off of Fed purchases in Q3.   Bernanke is likely to reiterate that the Fed is vigilantly watching the impact of QE on the financial markets and risk-taking generally.  However suspect it is too early for Bernanke to signal a shift in the pace of QE. Not only has the full impact of the fiscal tightening this year not yet been fully transmitted, but also the decline in core inflation readings suggests no strong urgency to alter the pace of the asset purchases.

There are at least eight ECB officials that speak in the coming days, including Draghi and Weidmann on Thursday. The official line is that the ECB is technically prepared to adopt a negative deposit rate, and there were rumors last week that it had contacted at least one bank to discuss.

Most analyses seem to focus on the potential unintended consequences. More problematic, we suspect are the unforeseeable consequences to financial disintermediaries of policies that frankly have not been tried by other major central banks. In addition, shrinking margins and attempts to secure deposits may become more challenging, for example, and could lead to new borrowing from the ECB or ELA (emergency lending assistance).  

Moreover, the intended benefits—to bolster lending, especially to small and medium size businesses-- may be elusive in the face of soft demand and recessionary conditions in much of the euro area, including several core countries.  We expected that when the cost/benefits have been analyzed, the ECB will decide to refrain from pushing the deposit rate below zero.  

The BOJ is the only major central bank meeting this week. Its two day meeting concludes Tuesday. For the most part BOJ Governor Kuroda must be fairly pleased. The growth is sufficient that the BOJ is likely to revise up its assessment of the economy. Inflation expectations, as revealed in the break-even rates of its inflation linked bonds have increased. The yen has weakened and the Nikkei has rallied. International resistance has been quite modest despite the traditional and social media playing up the “currency war” metaphor.

The main problem has been the Japanese government bond market. The increase in yields seems considerably earlier and more dramatic than officials anticipated. The marked increase in volatility is poses a significant threat to some market segments whose investment strategies that are particularly sensitive to shifts in value-at-risk models.  

Just like the low vol environment encouraged investors such as banks and leveraged accounts to trade large size, the increase in volatility is forcing them to reduce exposures. This aggravates the lack of liquidity and tends to reinforce the increase in volatility. The BOJ has already tried to alter is asset purchases, making smaller and more frequent transactions. 

 Officials may steps up their verbal assurances and large scale injections of short-term liquidity did help stabilize the JGB market at the end of last week.  Economic Minister Amari's comment that the yen's weakness has been corrected and additional weakness may be counter-productive, suggests heightened concern about the bond market.  

Minutes from the recent Reserve Bank of Australia’s meeting that resulted in a 25 bp rate cut will be released. We look for the minutes to reiterate the statement issued after the rate cut. Previously, the RBA had identified scope to ease and they used part of that scope. This still leaves the door open to additional rate cuts. Concerns about the impact of the strength of the Australian dollar may seem a bit dated given the recent slide in the Australian dollar, though by most measures, it remains significantly over-valued.

The BOE publishes minutes from the recent MPC meeting on Wednesday. The minutes will likely echo the sentiments of the latest quarterly inflation report in which the BOE shaved its inflation forecast and lifted its growth forecast. In April, three MPC members, including the governor, voted to resume gilt purchases. They have failed to persuade a majority. With stronger economic data and the proximity of Carney’s ascension, it will be interesting to see if there were defections from the minority.

At the BOJ, Kuroda was able to secure a majority in favor of new and more aggressive quantitative easing, even though some similar measures had been previously rejected by the same board.  The Bank of England is horse of a different color. The thinking seems to be more independent. Critics have harangued about Governor King’s management style, but he is a rare species of central bank heads that has allow himself to be outvoted on several occasions. Carney may find it more difficult than Kuroda in bending the central bank's monetary policy to his will.