Four Central Banks Meet but FOMC is the Key

(erratic updates continue while on this European business trip)

The most important event next week is the FOMC meeting followed by a press conference by Yellen.  In order to maximize its room to maneuver, we expect the FOMC statement will drop the patience that has characterized its forward guidance since last December.

This represents an evolution in the Fed's strategy to normalize monetary policy.   They have reduced the time of their forward guidance from around six months (considerable period) to two meetings (patience).  Yellen more or less executed the strategy that Bernanke outlined for tapering. Shifting away from the date-dependent approach to the data-dependent is under Yellen's leadership.

The Fed's biggest concern with the shift is that the markets will misinterpret this as a sign of an imminent hike.  As she did in her Congressional testimony, we expect Yellen to explain that this is not the case.  Indeed the next FOMC meeting April 28-29 and there is practically no chance of a hike then.  However, the June meeting, which is followed by a press conference, is a different story.

We continue to see June as the most likely time frame for lift-off, but recognize the risk of a short delay, as the Fed did when it began the tapering in December 2013 instead of September as many expected.   The data-dependency comes down to largely two considerations.  First is the continued improvement in the labor market, broadly understood.  Second, is that the FOMC has to be confident that inflation will rise toward 2% in the medium term.

Many participants recognize that the labor market is indeed healing.  It is the second condition that seems to be more troubling.   Yet this is precisely what the FOMC statement said at the last meeting: "Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate."

If the Fed does not drop the word patience, expectations of a June hike will ease considerably.  This would likely spur a dollar correction and a rally in US stocks and bonds. If the Fed drops the word patience but softens this inflation expectation, this would also be a dovish development and weigh on the dollar and lift stocks and bonds.  

We advise investors to pay little heed to the dot plots, which seem to be a failed exercise in transparency thus far.  We understand that at least some Fed officials are also frustrated with the dot plots but cannot simply be eliminated.  We would advise replacing the dot plot with press conferences after every meeting, like the ECB and BOJ.  This would also help maximize the Fed's flexibility by preventing gaming Fed actions at meeting in which there is a press conference schedule, as well as improve transparency, and enhance the Fed’s communication.  

Yellen has said that the Fed could call a press conference at any time.  This is a bit disingenuous.  For example, if the Fed does not raise rates in June, and calls for a press conference for its July meeting at which there was not one scheduled, the market would quickly guess what was about to be announced.  

Another concern many investors have regards the dollar's strength.  Even the longstanding dollar bulls like ourselves, have been surprised the speed of its ascent. Yet this is unlikely to deter the Fed for several reasons: 

1.  Several Fed officials have recognized that part of the dollar's rise is anticipation of a rate hike.  

2. Given the ECB and BOJ's monetary policy, there is a risk that the dollar continues to appreciate.  A delay in hiking now may only force the Fed to raise rates later when the dollar is even stronger. 

3.  Unlike Germany and China that export around 40% of everything they produce, US exports less than 15% of GDP.  

4.  As Yellen explained in response to a question during her recent testimony, the international variables, which include foreign exchange, oil and world demand, are broadly balanced.  The dollar's appreciation has been largely offset, for example, by the decline in oil prices.  

Three other major central banks meet next week.  In order of likelihood of action, we list them as Norges Bank, the Swiss National Bank, and the Bank of Japan.  Norway's macro fundamentals are constructive.  Unemployment is around 3%.   CPI is up just about 2% year-over-year, and 2.4% when adjusted for taxes and energy is excluding.  The mainland economy expanded by 0.5% in Q4 14.  These readings would be the envy of most high income countries.  Yet signals from the central bank have encouraged the investors to anticipate a 25 bp cut in the deposit rate to 1.0%.  The high expectations warn of the greatest risk of disappointment as well.  

The Swiss National Bank meets as the franc is beginning to strengthen again.  The euro finished last week at its lowest level against the Swiss franc since February 11.  If one believes that there is an "informal" band (CHF1.05-CHF1.10), then the risk of an SNB rate cut on March 19 to -1.0% appears significant.   While it is possible, we suspect the SNB will not appear to panic and respond to the price action at the very start of the ECB's bond buying.  It likely had anticipated some euro weakness.  The idea of the new range got the markets to do some of the SNB's heavy lifting of the euro, so that is was at a higher level at the start of the sovereign bond buying.  

The BOJ also meets.  The aggressive monetary easing continues.  The boost to inflation has not materialized, and the economy itself continues to disappoint.  Growth in the Q4 14 was revised down, but it gives the impression of a lackluster expansion.  Last month the BOJ raised its assessment of industrial output and exports.   

It is still not clear what the BOJ will do with its 2% inflation target for the fiscal year that starts next month.  It has always been difficult to see how it was going to be reached.  There seems to be a small number of choices for it.  It can deny, which is to say it can continue to stick to its target and not acknowledge what is happening.  It can downplay the under-shoot, attributing it primarily to the drop in energy prices. It can change its target from FY2015 to something somewhat more ambiguous, like the other central banks do, such as "in the medium term".

Both the Bank of England and the Reserve Bank of Australia release minutes of their policy meetings earlier this month.  In many ways BOE Governor Carney's seemingly dovish talk recently preempts the minutes,  The strength of sterling on a trade weighted basis is likely to be of greater concern for the BOE than the dollar's rise is for the Federal Reserve.  There probably weren't any dissents, which Carney seems dislike after former Governor King was repeatedly outvoted.

The RBA's statement after leaving rates on hold seemed clearly to keep the door more than just ajar for additional monetary accommodation.  Indicative prices indicate that the market has largely priced in not one, but two rate cuts in the coming months.  The RBA recognizes that the Australian dollar has made a significant adjustment already but wants to see more, and the market will deliver it.  Governor Stevens has cited the $0.7500 level as appropriate.  We anticipate a significant overshoot in the medium term.

Lastly, we note two other events that may be more interesting than market drivers.  First, the ECB's TLTRO tranche will be offered.  Unlike the 2014 tranches, this year's will depend on the increase of a bank's loan portfolio.  Loan growth has been improving but it is still weak, and with a negative deposit rate, banks may not be eager to take on more funds.

Second, the euro area reports its January current account surplus. Recall that in 2010-2011, the annual current account was roughly in balance (deficits of 9-11 bln euros were recorded).  The surplus began growing in 2012.  It averages 12.3 bln euros a month.  In 2013, the monthly surplus rose to almost 18 bln euros.  Last year, the average monthly surplus swelled to more than 20 bln euros.

The January balance is seasonally very weak.  This should not distract investors from the important change that has taken place. Some are trying to turn economics on its head and argue that the current account surplus is really negative for the euro because it leads to capital outflows.   Ironically, it is some of the same people who argued that the US current deficit is negative for the dollar.

The current account surplus means that a country is selling more goods and services and earning more on its foreign investments than it imports or pays out.  It is the amount of claims the euro area, in this case, has acquired.  Given that the gold standard does no longer exists, if the euro area does not recycle its current account into a capital account deficit (e.g. foreign portfolio and direct investment), the euro will appreciate.

The fact that the euro is falling (not to mention the momentum and depth) means that the euro area's current account surplus is being more than recycled.  It is particularly difficult to pin down precisely what capital is leaving.  To the extent that foreign investors are selling some of their European bonds to the ECB, they seem to be buying European equities.   However, there has been great interest in hedging out the currency risk in long-only equity funds.   In addition, European investors themselves appear to be moving savings out of the euro.