Conflicting Impulses Make for Treacherous Waters

The recognition that the Federal Reserve is most unlikely to taper this year succeeded US self-defeating fiscal exercise.  However, as the week winds down, it is the monetary policy of China and the Europe that is commanding more attention.  

The excess liquidity in the euro area has fallen below the 200 bln euro level that is perceived to consistent with keeping key short-term rates (EONIA) near zero.  The decline in excess liquidity appears to be largely driven by the repayment of LTRO borrowings, though there may be some other technical factors at work as well.  

The ECB says they can act if necessary.  We argued that its options are more limited than it may appear.  Rising EONIA will feel like a rate a hike even if the ECB continues to promise full allocation of the fixed rate refi (in effect giving banks as much funds as they have collateral for).   If we are right regarding the limited options for a policy response,then it suggest the bar for action to lean against an increase in money market rates may be high.  

In addition to excess liquidity dropping through the 200 bln level, the other level that needs to be monitored is the spread between EONIA and effective Fed funds.  As EONIA moves through the Fed funds rate, the incentive structure of the holders of liquidity change and this could push the euro higher.  

Separately, the Bundesbank's monthly report recognized that high real estate prices in many Germany cities.  Financial Times said this would "feed into concern that ECB policy is too loose". It is one of those claims that is difficult to falsify or verify.  But to be sure, inflation in the euro area, as investors will be reminded next week, is at three-year lows.  Disinflation folding into deflation is the larger threat than inflation. 

The UK is also experiencing rising housing prices, largely in London, but like in Germany, we do not see it as the key to policy pressure.   However, BOE Carney's view appears to be evolving and as early as next month, may indicate a shift away the guidance provided in July that a rate hike was unlikely before 2016.  The forward guidance was greeted by much skepticism in the market.  

The Canadian BOE Governor simply under-estimated the strength of the UK recovery, goes the criticism.   Ironically, as the CBI industrial survey warned this week, the momentum of the UK economy may stall in Q4, making the Q3 GDP due for release today less significant.  A modest acceleration of the economy for the third consecutive quarter is widely anticipated.   

Chinese money market rates have soared and many observers are concerned that this is purposeful action due a number of different macro-developments:  stronger than expected Q3 GDP, strong lending, higher CPI, and rising property prices.  

The PBOC has failed to offset the liquidity draining from the bank system due to the corporate tax payments.  It had been conducting 7- or 14-day reverse repo auctions to provide liquidity until last week.  On top of last week's drain of CNY44.5 bln there has been another drain of around CNY58 bln this week.  The 7-day repo rate, a useful benchmark, rose about 140 bp this week and at one point, according to Bloomberg, were as high as 5.20%.  

Don't under-estimate seasonal pressures at work.  Consider what has happen over the last couple of years.  Last year, the 7-day repo rate rose from 2.3% on Oct 23 to 5.15% before falling back to 2.50% by the Nov 1.  In 2011, the 7-day repo rate rose from 2% on Oct 21 to 5.10% and by Nov 4 was back to 2%.   

We should know in a few days whether the tightness in money market conditions is a policy decision, in which case they are likely to remain firm.  On the other hand, if it is seasonal, as we suggest, rates should ease soon.  

We note that other central banks, like Canada and Sweden's Riksbank softened their stances.  The Bank of Canada dropped the reference to the need for future tightening.  The Canadian dollar has been the second worst performing currency thus far week, losing about 1.2%, behind the New Zealand dollar's 2.1% decline. For its part, the Riksbank now suggests the repo rate will be at 1.15% at the end of next year rather than 1.25% previously forecast.