Fed: Sep 18

The US Federal Open Market Committee meet next Tuesday on what is probably the most important meeting for the Committee in 4 years. Recent financial market turmoil coupled with a slowing US economy has put the focus firmly on the Fed, with markets demanding an immediate easing in US interest rates and a shift in the Committee’s monetary policy stance. The Fed effectively moved from a tightening bias to a neutral stance in August, when it lowered its lending discount rate and issued a statement stating financial markets stresses now posed a downside risk to the growth prospects of the US economy. Last week’s payroll report which revealed a contraction in employment for the first time in 4 years, has, in most analysts minds, sealed a rate cut for the September 18th meeting, with futures markets pricing in a near 50% chance of a 0.5% rate reduction. While a rate cut seems probable, the Fed finds itself in an incredibly difficult position because recent surges in energy costs on the back of a weaker dollar pose a major inflation threat to the US economy going forward. The Fed must weigh up the risks and deliver a decision that will best serve the sustainability of US economic growth.

The Fed has a number of options available to it, which I explore below:

1) What I consider the most likely outcome is that the Fed will reduce the funds rate by 0.25%, while maintaining its inflation bias. The Fed will probably modify the statement with a sentence along the lines of ‘The Fed assess there are increased downside risks to the US economy in the coming quarters and the Committee will act in a timely fashion, when needed, to support US economic growth.’ This in essence will move the Fed into a neutral position and enable it to hike or cut, depending on how the economy plays out in the months ahead.

2) The Fed reduces the fed funds rate by 0.5% and shifts to an easing bias. This is what many market analysts have been calling for and was the most likely outcome as early as last week, according to futures markets. While this would certainly answer critics who accuse the Fed of not being proactive enough, it might translate into the Fed pressing the panic button and have them stand accused of merely being seen to bail out the financial markets. Outside of last week’s employment report, most other recent data does not imply a requirement for such a drastic move and in any event it seems highly unlikely that there could be consensus amongst all voting officials to cut the rate by 50 basis points.

3) The Fed cuts by 0.25% and shifts to an easing bias. This is a possibility but not a probability in my view. To shift to an easing bias the Fed would have to soften its concerns on inflation, signalling downside risks to economic growth now outweigh current inflation concerns. This will be interpreted by many as a confirmation that the US is headed for a serious slowdown/recession and that the market should expect a cycle of rate cuts in the months ahead. This would be damning for the dollar, should it happen. However, there is insufficient wider economic data to support such a negative view at this time and such a policy decision could in itself precipitate a major slowdown/recession.

4) No change in the Fed funds rate, but a modification in the statement to stress that the Fed are monitoring the situation closely and will act when needed. The Fed could throw in a 0.50% reduction in the discount rate to offset against the resultant disappointment in financial markets. This particular option is probably the wisest one in terms of acting in the the long-term interests of the US economy, but it will require incredible bravery on the part of the Fed. It is also likely this is the preferred option of a number of Fed officials, including Bernanke himself and if the Fed Chairman manages to deliver such a result he will cement his place in history as a Central Banker that stood tall against all the pressure, influence and power financial markets could garner to unsettle him. If we did not have the recent credit market crisis, there is no question but that the Fed would not be even considering a reduction in the fed funds rate next week. Given that the crisis was created by the financial markets themselves and the fact that no interest rate reduction is going to recover bad debts, the Fed should leave the fed funds rates unchanged next week. Other Central Bankers have shown little empathy for financial markets in response to this mess, so why should the Fed be any different?

What about the dollar?

The dollar has been sold off at a rapid rate in the past 2 weeks, to the point that the US dollar index has firmly broken below 80 and sits at its lowest level in 15 years. The market has priced in rate cuts of between 0.75% and 1% between now and the end of the year. Although it is clear the dollar sell-off is overdone, the dollar simply cannot attract any sustainable buying support right now because of the extent of negative sentiment that surrounds it. We are unlikely to know the true fate of the dollar until after next Wednesday, once the true implications of Tuesday’s Fed statement has sunk in. We could easily see EUR/USD break above 1.40 or 1.41 in the immediate aftermath of Tuesday’s meeting, if the Fed shift to an easing policy, as the market is exclusively dollar bearish right now. But we could see a knee-jerk reaction on either side come Tuesday which may prove to be premature and it is a dangerous time to be entering the market.

Donal Keane
14th Sep 2007

ECB: August 2nd

The ECB are in holiday mode and this week’s Monetary Policy meeting is being held by teleconference, hence we won’t have the Bank’s President presiding over a detailed Press conference after the rate announcement. Given this, it is a formality that rates will remain unchanged and we won’t learn anything new about how the members think about future rate prospects because the ECB don’t issue detailed rate announcement statement. We are getting some definite signs of late the euro economy may have already peaked and with inflation running at a tame 1.8% on a month when oil prices soared, it may well be that markets have to reassess the rate outlook for the euro. Markets have currently priced in 2 more rate hikes this year, one in September and one in December.

BoE: August 2nd

Since the Bank last met in July, nearly all tracking indicators signal that UK house price inflation is slowing, the housing sector finally responding to a series of 6 rate increases in just 11 months. Inflation has also softened in the past 2 months, down to a 2.4% rate in June and there appears little reason for the MPC to tighten again in August. The minutes of the July meeting reveal that 3 members of the Committee voted to keep rates on hold, while a further 3 that voted for a rate hike were not as hawkish about future rate hikes, so there seems little prospect of an increase this week. The risks going forward for sterling could be firmly on the downside as recent data does not point to rates going beyond 6% this year and even a hike to 6% is not assured, although markets have it fully priced in. The Bank of England statement is unlikely to provide any detail so Thursday’s announcement won’t have any immediate market impact. Do expect investors to pare back sterling positions in the coming weeks though, which should see the currency decline.

Donal Keane
31th July 2007

ECB: July 5 at 11:45 GMT

The European Central Bank will keep rates on hold at 4% but the markets will be listening intently to the MPC President – Jean Claude Trichet, for any signals that rates will be raised in forthcoming months. Markets expect a rise in rates to 4.25% in September, with one more rate increase before the end of the year, to bring the underlying rate for the euro group of countries to 4.5%. ECB members have been decidedly hawkish of late and with oil prices back over $70 a barrel, it will be a surprise if Trichet does not point to price stability risks in the medium term. The Bank should retain its 'accommodative’ policy and reiterate that interest rates remain ‘moderate.’ Despite the fact that inflation has been held below the Bank’s target 2% level all year, the euro zone economy is expanding at a higher rate than forecast and with this week’s manufacturing and services indices revealing increased expansion in June, the MPC will certainly feel the economy has plenty of scope for further monetary tightening. While retail sales have faltered in recent months, employment numbers across the zone have hit new highs and the Bank foresee increased spending in the second half of this year. Trichet should signal on Thursday a rate hike to take place within the next two months and markets should be left with an impression of 1 further rate hike this year. Anything less could send the euro into retreat.

BoE: July 5 at 11:00 GMT

This is difficult to call because of the vote at the last MPC meeting in June, when the Governor found himself in a 5-4 minority - the committee voted to keep rates on hold. Since that meeting we have seen a series of weaker inflation data, although there appears to be little letup in the rise in house prices. Hawks on the Board will be helped by some recent economic data, where we saw quarter one GDP revised upwards to 3%, further tightening in the employment sector and a widening in expansion in the country’s services sector. With markets expecting rates to climb at least twice more, the hawks will be trying to force home a rate rise this month and will see no point in waiting until August. The result will depend on the hawks being able to bring at least one of the doubters over to their side on Thursday. Governor King irresponsibly intervened in the debate the day before the UK consumer price inflation data for June was released a few weeks back, when the timing of his blatant call for further rate rises biased the market's response to actual data. This had the impact of elevating the country’s currency and keeping it there, despite the fact that consumer prices the next day reported a sharp decline in the annual inflation rate from 2.8% to 2.5%. If the MPC fail to approve a rate rise Thursday, Governor King’s authority and influence will be seriously undermined again and he may rightly find himself in an untenable position. The lack of direction and consensus from the Bank of England over the past 12 months has been startling to say the least and this Thursday could be another day when the MPC does not cover itself in glory. Of course we will not know what exactly transpired for 2 weeks, when the minutes of the meeting are released. There remains a very good chance that rates will not rise this Thursday as it makes sense for the MPC to wait until August, when the Bank's quarterly inflation report is due to be released. The reasons for voting against a rate rise in June still hold true in July and with the MPC not having access to the latest consumer price inflation data (it is not released until July 16), it makes sense to wait. It will be a close run thing, that is for sure, but whichever way it goes, it could prove to be another uncomfortable day for the Bank’s Governor – Mervyn King, who has failed miserably to exact any meaningful influence over this particular MPC.

BoC: July 10 at 13:00 GMT

The Bank of Canada has an unenviable task ahead of them next Tuesday, having all but signalled to the markets in their statement at the end of May that a rise in interest rates was a near certainty. The Bank made a cardinal error by showing their hand too early, because it came at a time when the Canadian dollar was appreciating at unprecedented levels and came before the country’s latest inflation data release (for May) which subsequently saw a decline in both the country’s headline and core inflation rates. Since the beginning of June economic data out of Canada has been less than impressive, with lower than expected gains in employment, manufacturing output falling, retail sales slowing significantly and growth flat into quarter 2. Despite this, the Canadian dollar has been appreciating to new 30 year highs against its US counterpart, as speculators bet on 2 or more rate rises from the country’s Central Bank and trade the currency like it was a commodity. There are plenty of arguments for why the Bank should keep rates on hold this month, but the fact they have already signalled to markets that rates ‘may’ rise, means they will probably have to make good their promise and proceed with a 25 basis point hike this month. The Bank has quite a complex procedure for determining monetary policy, and the whole process begins this Friday, with the decision only announced next Tuesday. The Bank chose to refrain from commenting on the value of the Canadian dollar in its last statement, which was another mistake, as it in effect gave license to speculators to push the currency higher and higher, even against a background of softer data. The Bank would do well to look at the experience of the RBNZ that made a failed attempt to rein in the currency – after having raised interest rates there to levels that were going to cause serious problems for the currency. If the Bank of Canada go ahead with a rate increase next Tuesday, as expected, and leave the door open for possible future rate rises, then they will have lost control over the direction of the country’s currency. The dependency of Canada’s economy on the US market is enormous, but the overvalued Canadian dollar may ultimately prove to be the economy’s downfall and the impact may be seen sooner rather than later and subsequently lead to a reversal in monetary policy.

Donal Keane
4th July, 2007

ECB (June 6)

There is little doubt but that the ECB will hike rates for an eight time in 18 months, when they meet this Wednesday, to bring the euro zone’s base rate to 4%. The real issue concerning markets is what will happen to euro rates thereafter. The ECB’s Weber was quoted last week as having said the ECB would refrain from using code words to signal future rate hikes, so we expect a new approach from Jean Claude Trichet in his post announcement press conference this week. Economic data from the eurozone is holding up positively, despite the recent rate rises, so the Bank could justify continuing a hawkish line if it so chooses. It is likely that no further rate hike is on the agenda until at least September, so the ECB may decide to kick the issue to touch and adopt a ‘data dependent’ wait and see approach over the coming months. The MPC will justifiably feel vindicated by their policy strategy as the euro area economy continues to grow impressively, while inflation has firmly been held below 2% since last summer. The most likely outcome Wednesday, is for a hawkish Trichet to keep markets guessing, but appearing hawkish enough for markets to price in one more rate hike after this week. Anything short of a stern warning on price stability/inflation will be perceived as a softening in stance and if the MPC are seen to be backing off, then the euro could be in for a prolonged retreat over the summer months.

BoE (June 7)

Last month’s MPC minutes sent the market into a tizzy, with the unanimous 9-0 vote for May’s hike seen as a slant towards further tightening, possibly as soon as this month. Sterling has advanced on the increased rate prospects but the reality is that the Bank is almost certain to keep rates on hold this week and issue no statement on their deliberation Thursday, thus keeping markets guessing and most likely sending sterling backwards. The Bank will however have sight of May’s CPI data (not published officially until June 12) and if this reveals an inflation climb to over the 3% rate from last month’s 2.8% rate, there remains a remote outside chance of a hike this week. The minutes from the Bank’s last meeting reveal an MPC who are as unsure as to the direction of inflation and thus interest rates as the rest of us. Mervyn King, and by association the MPC, keeps referring to market expectations for where interest rates will be at later this year - in effect telling us the MPC does not have a consensus opinion of its own. The smart money is for one more rate hike, probably in August, but with UK data very much mixed of late, the prospect of no further UK interest rate hikes is also beginning to become a possibility. With the MPC unable to offer any intelligent insight, it is left to the market’s own devices to interpret the economic data as it is released, and what it may mean for interest rates going forward. The first instalment in this regard is not due until next week, when May’s consumer price data is released.

Donal Keane
5th June, 2007

As we speak, the Canadian dollar has hit a low (1.5590) against the euro not seen since May 2005. Although the Canadian economy hit a rough patch in the latter half of 2006, the economy has shown strong signs of recovery this year, with economic fundamentals reflecting a marked improvement thus far in 2007. In the most recent economic outlook report from the OECD for developed nations, Canada was the only economy of the leading nations that was seen to expand in the coming months, with a general slowdown being forecast for the wider group. Commodity prices, important to Canada’s corporate coffers, have rebounded in the past 2 months and Canada’s burgeoning trade surplus and massive energy reserves make it the envy of rest the world. Employment is flourishing and the Canadian construction sector has been booming, unlike in the US. So why is the country’s currency behaving like that of an emerging country, at the wilful mercy of currency speculators?
There are a number of factors / reasons:

1) Trends. The Canadian dollar has been on a downward trend across the board since last summer, a decline that sharpened from October through to the end of the year. In the past year alone, the loonie has lost 14% of its value against the euro. That is a remarkable downward slide and the problem with long-run trends is that they are difficult to reverse, even when the fundamentals improve. Traders have gotten used to selling Canadian dollars and it will take quite a sizeable jolt in the other direction, before this selling mentality shifts.

2) Growth. The Canadian economy slowed considerably in the second half of 2006 and in fact it was the worst performing of all leading nations in quarter 4, recording an annual GDP rate of just 1.4%. Although growth has picked up significantly at the start of 2007, it is difficult to shift the negative market sentiment towards the currency, caused by the poor economic performance in the last two reported quarters.

3) Interest rates. Canadian interest rates have been on hold since last summer, at a time when interest rates have been on the increase in Europe and even in Japan. The Canadian dollar has become a less attractive currency to hold because of the widening in interest rate differentials between the loonie and other currencies like the euro and the pound.

4) Big brother / little brother pushover syndrome. Current concerns over a slowdown in the US economy are having a greater impact on the Canadian dollar than on the US dollar. If data is negative for the dollar, it is more negative for the loonie. Canada is one of the world’s most important providers of commodities, from oil to base metals and to precious metals. It is an export dependent nation. The Canadian economy is inextricably linked with that of the US - the US provides Canada with the bulk of its export market. If demand in the US falters, so do Canadian exports and consequently the Canadian economy. Traders have been finding it relatively easy to kick the Canadian dollar, when the US economy misbehaves.

5) Speculative positioning. There has been a very strong wave of short positioning against the Canadian dollar in recent months and even with a major revival in the economy’s fundamentals, traders have continued to stack short positions against the currency. The latest commitment of traders report from the Chicago Mercantile Exchange reveals that there are currently more short positions held against the Canadian Dollar than for any other of the major currencies. This is a startling statistic and given the shift in fundamentals of late, any one event could trigger a massive unwinding of these shorts which could see a very sharp appreciation in the Canadian dollar in the not too distant future. Despite several attempts in recent weeks by the loonie, its progress each time has been halted and reversed, not by a change in fundamentals, but by determined and successful efforts by unknown sources to keep the currency down.

6) Risk aversion. The Canadian dollar appears to have come off worse than nearly every other currency during the 2 financial market bubbles we have experienced in the past few weeks. First there was the unwinding carry trade, which saw the loonie lose over 2 cents to the US dollar in a few days. It is difficult to understand just why the loonie was targeted, given the fact that the volume of carry trades involving the loonie must have been small. Its interest rate – at 4.25%, is not amongst the most attractive on offer for carry traders and given the loonie has been on sharp downward trend since last summer, loonie longs must have been few and far between and all carry traders should have been long since sold out of the currency. This week’s scare about US sub-prime mortgages is more understandable in terms of its impact as it raises wider questions about the soundness of the US economy and by association the outlook for Canadian exports and the loonie. However, as to why the loonie should plunge more than the dollar is something of a mystery, but that is probably another example of the little brother pushover syndrome, which is shaping market sentiment right now.
Will the loonie ever come back with more than a whimper? Yes! Improving fundamentals demand a stronger currency and markets cannot ignore facts for too long. The timing of a real loonie revival may depend on US fundamentals as much as on Canadian ones. A stronger dollar would no doubt see an even stronger loonie, but given the current positioning against the Canadian currency, a single event could trigger a long overdue appreciation and genuine trend reversal. As to what that event may be, we just don’t know, but we sure don’t want to miss the bus.

Donal Keane
March 14th 2007

Both the ECB and Bank of England meet this Thursday and the outcome will have a major impact on the direction of each currency over the next month or so. The ECB will be raising rates to 3.75% but the key question is what will happen to rates thereafter. The market is expecting at least one more rate hike, probably in June, but in view of recent economic data and the uncertainty surrounding the prospects for the global economy going forward, a further rate hike is by no means assured. If the ECB President – Jean Claude Trichet, is perceived as being dovish in any way on Thursday, then the euro could face a backlash and we could see EUR/USD retreat to below 1.30 again. With euro zone inflation currently standing at a mere 1.8% combined with scares about the direction of the US economy and the euro economy itself showing signs of having peaked, Trichet may find himself unable to be as hawkish as he has done at recent meetings. While he is sure to refer to the upside risks to inflation of changes in energy costs, those seeking some concrete referral or coded signal, for a further impending rate hike, may well be disappointed. It will also be very interesting to see how Trichet responds to questions as to the ‘cause’ of the recent sharp reversal in global financial markets, a question he is sure to be asked.

The Bank of England has become something of an enigma in recent months and one never quite knows what to expect from them. Given their appetite for delivering the unexpected, a further surprise rate hike this week is not beyond the bounds of possibility. Production output, bank lending and house prices have been very robust in the past month and if February’s inflation data sees UK consumer prices on the rise again, then the Monetary Policy Committee may feel justified in acting now, rather than wait. Against that, UK retail consumption slumped in January and the country’s key services sector slowed in February. Fears over excessive inflationary earnings awards in the recent wage round have largely abated. Some Committee members are likely to opt for an increase this month, given that a minority two members voted for a rise at the last meeting. Unless consumer prices have risen unexpectedly again in February, it seems likely that the Committee will opt to keep rates on pat, allowing more time for recent rate increases to bed into the economy and to take a stranglehold on prices. The market certainly doesn’t expect a rate increase this week and if the Bank were to surprise yet again, then given the turmoil in financial markets over the past week, it may well prove to be this Committee’s least popular and boldest move to date. The Bank’s recent Inflation Report stated a requirement for a further rate increase in the second quarter, to bring inflation to within the target rate by the end of the year. We are not yet in the second quarter, but then again this is the Bank of England we are talking about.

Donal Keane
March 6th 2007

Just a month ago, when the Bank of England surprisingly raised interest rates to 5.25% and UK consumer prices reached 3.0%, the pound raced to a fresh 14 year high against the dollar – hitting 1.9915, thus forcing markets to price in two more possible rate hikes in the months ahead. Fast forward to this week, when January’s key inflation numbers were released and the turnaround has proven to be quite remarkable. Given the time lag required for interest rate hikes to feed into consumer price inflation, it is not credible to believe that the Bank of England’s sudden hike a month ago is the reason for a serious easing in inflation in January. That should come in the months ahead.

Let’s look at the figures: producer input prices down 2.0% since December and down 1.6% from January 2006, the annual rate of producer output prices in January eased from 2.2% to 2.1% (obviously cheaper inputs are not resulting in cheaper product for end customers), the annual rate of headline consumer prices eased from 3.0% to 2.7% in the month to January, core consumer prices eased from 1.8% to 1.6%, retail prices eased from 4.4% to 4.2%, wage inflation including bonuses eased to 4.0% from 4.1%, manufacturing units costs down 0.2% in the 3 months to December etc.

February’s Inflation Report suggests that UK inflation will not moderate back to the target 2.0% rate without one more interest rate increase, which oddly enough the report states will not occur until the second quarter. Does this mean further tightening is off the agenda for the Bank of England in March? Apparently so, unless perhaps February’s consumer price data moves back up towards December’s levels. One might wonder, why, if the MPC are so sure inflation will not moderate without one more rate hike, they do not just hike rates in March. Why wait? The MPC are obviously not at one on this question and those members that voted for rates to remain on hold in January will now feel vindicated by this week’s data.

Sterling has largely been in a state of confusion this week, with markets unsure as to whether the currency should be moving up or down. Sterling fell to 1.94 Tuesday against the dollar after that surprising drop in consumer prices, only to jump to 1.9650 Wednesday, following publication of the Bank of England Inflation Report and a broader dollar retreat. We should witness a continuation in the recovery of the euro against the pound though, as the extent of future tightening and interest rate differentials would now seem to firmly favour the single currency, following this week’s data.

Donal Keane
Feb 14

The Central banks of the two European majors meet again this Thursday and the markets wait anxiously to see if either party is going to pull any rabbits from the hat this month.

ECB President – Jean Claude Trichet, surprised many in January when he failed to signal a rate rise for the Bank’s next meeting in February. That effectively means rates will stay on hold this Thursday. The market does however expect Trichet to resurrect the word ‘vigilance’ this week, which is a coded signal to the market for a rate hike when the MPC are to meet again, i.e. in March. However, if one looks at the data over the past month, which has been largely mixed, then the market could find itself surprised again Thursday, because there is ample justification for the ECB to hold out for longer. The crucial ingredient is consumer price inflation. Last week, Eurostat published January’s euro zone inflation estimate, which came in flat for the third month running, with an annual rate of 1.9%. Economists were expecting a rate of 2.1%. As the annual inflation rate of 1.9% is inside the ECB’s tolerance level of 2.0%, the ECB will be accused of being heavy-handed if it raises rates again against this inflation background. That in essence rules out any remote possibility of a rate hike this Thursday, but it also raises the possibility that the ECB may choose not to signal a rate hike for March either, giving it an extra month to assess fresh data. While concerns over money supply have been heightened, as M3 money continues to grow, many key business sentiment indicators have softened in the past month, indicating that growth may already have peaked. There is also the problem of the widening diversification problem between the performance of the German economy and the other major economic blocks that make up the euro zone. Against a platter of mixed signals and unknowns, the most sensible course of action for the ECB may be to wait another month and thus to deliver the same message to the market this month, as they did in January. It will be embarrassing to signal a hike now for March, if data were to dictate a different outcome later.

As for the Bank of England, their ability to surprise markets has left many with deep scars in recent months and nobody dare assume the outcome of Thursday’s meeting until the actual rate announcement itself is published on the Bank’s website. The closeness of last month’s vote, when the Bank voted to raise rates unexpectedly by a 5-4 majority, gives some insight into the difference of opinion within the current Committee. Wile debate may be seen to be healthy, the fact that the Bank’s Governor failed to deliver a more decisive vote, points to serious problems with his ability to influence the committee’s other members, which must be a major concern for the Government. To resort to having to surprise financial markets once in 6 months might be construed as a necessary evil, but to do so twice in that period signal something much more worrying. Most economists expect rates to remain on hold this Thursday, but financial markets are not so sure, with many participants deciding to err on the side of caution. It can be assumed that the 4 members who voted to keep rates on hold last time round will do so also this week, so it will only take one of the other 5 to vote with them, to maintain the current rates.  What the market does not know however is what January’s inflation figure is. The MPC will have access to this data as they deliberate on their decision. It is wholly unsatisfactory that critical inflation data is not published prior to the BoE’s monetary policy meetings and this coincidently is the principal reason why markets are so susceptible to surprise rate hikes. Had markets gotten print of the 3.0% CPI figure in January, prior to a rate announcement, then financial markets would have priced in a high probability of a rate rise in January, rather than February. Economic data out of the UK has, for the most part, been firm over the past month and the danger must be that inflation will not have dissipated at all, but in fact it may have appreciated again. Against this backdrop and given he market has fully priced in a rate hike for March, could the MPC hike rates again this week? December/ January is a traditional spending time of the year for UK consumers and house markets are in non-seasonal mode, so it might be premature for the MPC to rise rates so quickly again. Indeed, the real impact of both the November and January rate hikes could take a few months to impact on economic data, so a further hike now could seriously damage the economy in the medium to longer term. But given the MPC’s recent track record, should we be surprised?

Donal Keane

Much has been documented of late with respect to the demise of the currency of the world’s second largest economy. The Japanese yen currently stands (30 Jan) at a 4.5 year low against the US dollar, has been hitting all-time lows against the euro almost on a weekly basis for the past 6 months and last week touched a 14 year low against sterling. In the past 18 months, the euro has gained 18.7% against the yen, while the pound has gained almost 20% in the last year alone. While Japanese authorities have been the first to cry foul about the failure of the Chinese yuan to appreciate, they have been deafening in their silence in response to the virtual collapse of their own currency. Why? Much of the blame for the yen’s depreciation can be put at the door of Japanese political figures that constantly undermine both the currency and the independence of their own Central Bank. Japanese politicians have long had a strategy that a weaker currency is in the best interests of their country with Japan being a predominantly export-oriented economy. In exchange-rated trading terms, the yen registers as the most under-valued currency of all developed countries right now. Yet Japan has a current account surplus the envy of the world and year-on-year trade surpluses registering 40%+ increases are not uncommon for the country. So why is the currency in freefall? I offer 3 major reasons, in order of significance.

1) Carry Trades --> Because Japan has such low interest rates (0.25%), traders have been funding investments in other higher yielding securities and currencies using the yen. The sheer volume and extent of the carry trade appears to have grown increasingly in the past 6 months. One has only to look at the performance of the Swiss franc in the same period to realise that this is not purely a yen phenomenon. It is interesting to see how easily good economic news out of Japan is dismissed so quickly by the market, against how easily the yen is sold off when economic data is not so good. The underlying fact is that the yen is being used to fund investments elsewhere and those borrowing the yen to fund these other investment s are going to continue to do so as long as they can get away with it. The global carry trade is now so heavy that it is going to take some significant event to dislodge the weight of short positions currently held against the Japanese currency. If the authorities that be (Central Banks and Governments) leave the fate of carry trades to such a major event, then a single major issue could lead to a sharp unwinding and collapse of the carry trade that could wreak havoc for financial markets.

2) Domestic consumption --> The principal reason why the Bank of Japan has been unable to raise Japan’s low interest rates is because the Japanese domestic economy remains rather brittle. The Japanese consumer is simply not spending money and domestic demand is stagnant. While wage growth in Japan may have been modest in comparison to some other countries, spending has actually been in decline. Prices have hardly increased, because Japanese retailers are competing for a smaller pot of cash. We could in fact see consumer prices shift back into deflationary mode over the next few months, something that could stall indefinitely any prospect of the Bank of Japan raising rates. This in itself does not explain the current low value of the yen as the Japanese economy has been in this sort of domestic economic predicament for much of the past number of years. But it serves to demonstrate how dependent Japan is on its export industry and why the Japanese Government are not complaining too much about a weak yen.

3) Bank of Japan --> The Bank of Japan has the least credibility of all the major Central Banks right now. The recent debacle regarding the ‘no rate hike’ in January diminished their reputation even further and their independence has largely been called into question. The ongoing interference from Japanese politicians, airing their public opposition to rate increases, highlights the fact that in Japan, monetary policy tends to be as much politically as economically driven. Add to this the poor communication that exists between the Bank of Japan and financial markets and you have a recipe for trouble. Much of the muscle behind the carry trade in recent months has come directly from the perceived weakness and willingness of the Bank of Japan to react in any way. The euro’s uninterrupted ascent against the yen since last summer reveals an unusually one-sided and worrying trend amongst two major currencies. The Bank of Japan has thus far failed to address the weak yen issue at all, let alone do anything about it. The truth is that it may be powerless to do so, as it appears gagged from a fear of offending the government. Recent comments from Japan’s Minister of Finance who dismissed the issue and said that the yen’s current value reflects economic fundamentals give an indication of where the Government sit on the issue. The Japanese Government seem happy to tolerate a weak currency to grow exports, but they are playing a dangerous game. With the failure of the either the Japanese Government or the Bank of Japan to act, it may be left to other global players to address the worrying imbalance.

Donal Keane

On the evidence of December’s inflation data which was released this week, few can argue with the MPC’s decision to increase rates now, rather than wait until February, when the markets expected a rise. How could they wait! If they decided to hold back for a month and inflation crept up higher this month and the ‘so-called’ dreaded letter had to be sent to the Chancellor on February 8, then our esteemed committee might have been out of a job. They did what any sane monetary policy committee would have done, when faced with the facts in front of them. The problem though and the key question which remains unanswered is – how did it come to this? Back in early summer last, the Bank’s Governor felt and gave strong indications that the Bank’s then rate of 4.5% would remain on hold until the end of the year. We now know the Bank raised rates twice, once in August and once in November. The August hike was another bolt out of the blue as far as financial markets were concerned, it being the first rate change in a year . The Bank’s management of that whole episode was heavily criticised at the time, probably rightly so.

But fast forward to November, after which rates were raised again, the MPC should surely then have read the warning signs on inflation, in that the economy was growing above trend, employment was beginning to tighten and there was ample evidence that lower fuel costs were not being fed back into UK consumer prices, like they were in the rest of Europe and in the US. They tightened then when annual inflation was at 2.4% and when they met in December the rate had risen alarmingly to 2.7%. While they might have been justified in believing that it would take more than a month after a rate hike for inflation to moderate, one would have expected them then to be more than a trifle concerned. That is after all their job. Had the MPC then sent a strong signal that they might increase rates at their next meeting – January, if inflation had not improved, then their integrity would not now be called into question. The problem with a shock rate hike, like we’ve now had twice in a short period from this Board, is that consumers and spending patterns have not been conditioned for it, thus the behavioural spending patterns that the Bank is ultimately trying to curtail, is effectively delayed for a month, making their task all the more unenviable. This shock timing also has a significant impact on currency markets, particularly during a tightening cycle. There is ample evidence to show that sterling has appreciated well above the normal levels over the last 3 BOE rate increases.

It is worth noting that sterling has risen 4.2% against the euro since August and in the intervening period both the BOE and the ECB have tightened 3 times, with neither adjudged by the markets to be at the end of their respective current tightening cycles. Sterling’s gains against many other currencies during the same period have been seismic by any stretch of the imagination and sterling is now the most expensive fruit in the basket. For this, those members of the Bank’s MPC won’t be getting too many pats on the back from UK exporters, whom are now forced to cut their prices dramatically just to compete, that is if they are lucky enough to survive at all.

Donal Keane

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