Tag Archives: monetary policy and exchange rates

Yellen’s hurdle

Discussion and Analysis by Charles Porter:

 

The Federal Reserve Board’s Chair, Janet Yellen, has serviced in her present office since 2014. Her four-year term ends in February 2018 and her reappointment looks uncertain at best. Regardless of whom the White House appoints as the next Fed Chair and Chairman of the Federal Open Market Committee, the body responsible for setting interest rates, a pivotal moment of Yellen’s appointment in office will fall upon her and the Committee that she is, at least for now, heading.

 

Dollar weakness was eroded gradually last week, carrying through the weekend, with mild corrections manifesting throughout the middle of this week. This was in considerable part down to the considerable action and apparent hawkish sentiment hidden within the US Fed’s seemingly dovish policy action. The dot plot, a measure published detailing the stance of each of the Federal Open Market Committee members about the future progression of US monetary policy, still suggests a before-year-end tightening of monetary stimulus and the fulfilment of foreboded quantitative easing stimulus.

 

Quantitative easing has been pursued within the US to try and stimulate the economy using the preferred instrument of monetary policy whilst interest rates have become useless; once they approach the zero-lower bound. However, quantitative easing has ballooned the balance sheet of the federal reserve board immensely, with an estimated 4.5 trillion dollars on account. The indebtedness of a central bank is not a problem, as it may be with a corporate or government institution. Unconstrained purchasing is, after all, the primary capacity of a central bank, differentiating it as a unique form of financial institution.

 

However, what is problematic is crowding out, whereby central bank purchases are precluding open market demand from realising their assets and artificially inflating the price, or lowering the yield unsustainably within bonds. This can lead to the view that the reduction of monetary policy stimulus is implausible and markets simply could not take over the burden that a central bank has taken upon itself. Therefore, markets can become jittery, especially if they feel the rate of tapering or the cessation of re-investment is excessive.

 

However, the ultimate tool that a central bank has is not really the interest rate or the capacity to purchase bonds. As our interview within Dr. Waltraud Schelkle of the London School of Economics further attested to, credibility is the real life-line of a central bank. Therefore, the expectations alluded to above must be fulfilled for markets to credibly internalise the forward guidance of a central bank and make their future actions credible.

 

Evidently, if hard data precludes the central bank from implementing a previously announced or foreboded policy action, i.e. if the action would be damaging to the present economy, then the bank will lose credibility from implementing a previous plan anyway. Central banking therefore frequently appears as a juggling act of expectations and pragmatism, as much as economics.

 

This afternoon, at 13:30BST, the Bureau of Labour Statistics will produce a Consumer Price Index report detailing the inflation characteristics within the US economy. Given that the mandate of a central bank is orientated around the inflation rate and price stability, this will be one of such hard data that will, to a significant extent, determine how the Fed’s juggling act plays out. The decision that Yellen’s Federal Open Market Committee takes will set a legacy for the next Chair and, for that matter, the members that join this individual according the present Committee vacancies.

 

Market sensitivity to the inflation rate publication will therefore be high. A higher than anticipated rate of inflation will lead to a strong appreciation of the US dollar. However, a failure of inflation to pick up, a trend that many economists and central bankers have warned about, will cause a shock depreciation while the potential reward of a future higher rate of interest is priced out of US Dollar currency pairs. Individuals exposed to or looking to gain exposure to the US Dollar will be well advised to pay close attention to this afternoon’s publication.

 

While the labour market report published at the end of last week is usually a good indicator of price level mechanisms, the distortions within that data due to the natural disasters that the US has recently suffered may weaken it as a predictor of the macroeconomy and inflation. The report showed payrolls worsening yet the rate of unemployment falling; an apparently contradictory result. Whilst market sensitivity might be diminished by expected inaccuracies and the attested ambivalence to present low inflation within the Committee, the aforementioned expectations still stand.

Data Light and Talk Heavy

Discussion and Analysis by Charles Porter:

 

Whilst the headline above may be many people’s aggregate impression of financial markets and politicians regardless of the short-term conditions, it is certainly the general impression of this week. With only minor data released within the UK on Tuesday and significant US data waiting until Friday, once again, the musings of Central Bankers in organised speeches will continue to be the main market-only news of this week.

 

The main driver of foreign exchange markets over the past weeks have been related to monetary policy. The hyper-low interest rates and stimulus programs that seem to be an ever-enduring paradigm of the macroeconomy at present may finally begin to be unwound. Interest rates within most developed economies have been threatening the zero lower-bound either since the financial crisis, or, in the case of the Eurozone, following the start of the European Sovereign Debt crisis.

 

In this low interest environment, an interest rate hike has a double and mutually enforcing effect. Firstly, the interest rate at face value raises the reward for saving and investment. Speculative investment and asset allocation will therefore favour an economy and interest rate that provides higher rewards. The associated currency will therefore receive a boost, derived from heightened international demand for the currency, that will spill over into value of the domestic currency.

 

However, the second, and arguably equally important, effect derives from bucking this enduring monetary policy and economic paradigm. Raising interest rates immediately signals the belief of a central bank, and therefore probably economists alike, that the economy can contain higher rates of interest. Therefore, it signals that domestic and international investment and public debt will be sustainable when the returns upon deposits and assets increase.

 

The latter belief will signal that the economy is returning to health and, following such prolonged periods of hyper-low interest, output and growth may prevail. This effect will clearly also lead to the purchase of the associated currency because it signals that economic performance may well rise in the near future. If a currency appreciation can be called an advantage, something that it is often not labelled as due to the negative effect upon domestic export markets, then there is certainly a first mover advantage. With hyper low interest rates pervading throughout almost all developed, credit- and investment-worthy nations, the first to reward significant rates of interest will receive considerable capital inflow given the rising opportunity cost associated with its counterparts.

 

With the absence of considerable data outside, perhaps, Tuesday’s UK trade balance data and Friday’s forthcoming US CPI inflation, the main highlights are likely to be found within further speeches made by central banks. Of particular importance within these speeches will be President Draghi’s remarks later this afternoon alongside other members of the European Central Bank. Whilst the White House considers the nomination of Federal Reserve Chair board, a lot of interest will continue to be paid to US monetary policy.

 

The widely priced in probability of a rate hike coming from the US before year end, QE tapering announcements within the Eurozone likely to be guided forward as of October to start in January 2018, and an uncertain yet likely Bank of England rate hike before year end, all mean that any signal or comment suggesting that a hike is less likely will create a greater distortion within money markets than a positive signal. Therefore, there is likely to be greater downside risk associated with each of these pivotal speeches than upside potential. Therefore, until the official respective meetings of the world’s key central banks and until the next Federal Reserve Chair is appointed, meetings are unlikely to produce domestic currency market appreciations.

Australian Dove

Discussion and Analysis by Grace Gliksten:

 

For the fourteenth month in a row, the Reserve Bank of Australia, RBA, has left the Cash Rate on hold at 1.50%; a trend that seems unlikely to change in the coming months, due steadfast adherence to a neutral bias. Unsurprisingly, the Australian Dollar reacted negatively. Surprisingly, the response was moderated and shortlived…

 

Continuing the global optimism he displayed in September, the RBA Governor, Philip Lowe, introduced this month’s Monetary Policy Decision by saying that ‘conditions in the global economy have improved’. Lowe also showed partial optimism for the Australian economy by highlighting the 0.8% growth in the June quarter and acknowledging the employment growth over the last few months.

 

Amidst the stagnation of the construction and mining sectors, Lowe even proclaimed that ‘non-mining investment is picking up.’ This is particularly significant given last week’s speech from the Head of the Treasury’s macroeconomic division, Nigel Ray, who claimed that Australia’s most influential economic event has been the mining boom; claiming it to be more influential than the global financial crisis.

 

Lowe’s optimism did not come without concern. For example, the Governor highlighted that wage growth had remained low and was expected to continue that way for some time. In the five years since the mining boom’s peak, the average wage growth has declined by over 1%. When inflation is taken into account, real wage growth has halved. Taking a more pragmatic stance on low wage growth, Scott Morrison, Treasurer, said in a speech last week that, ‘in Australia, wages growth has been heavily impacted by mining investment boom washing out of the system, as the economy attempts to rebalance itself from the extraordinary terms of trade boom that fuelled our nation’s prosperity for almost a decade.”

 

The decision to hold rates had a moderately significant effect upon the Australian Dollar-Pound Sterling currency cross. The interest rate is a monetary policy tool used by central banks to manipulate the macroeconomy. Representing both the reward for saving and the cost of borrowing, interest rates can manipulate the attractiveness of prospective domestic currency exposures.

 

Philip Lowe’s central bank chose not to change interest rates, thereby leaving the cost of borrowing and reward for saving at a record low. This has a two-fold effect on the Australian Dollar and economy. Firstly, by not raising interest rates and raising the reward for saving and investment, outside investors are disincentivised from increasing their exposure to the domestic currency and economy. Secondly, by keeping interest rates at record lows and refusing to increase them back up to ‘normal’ levels, confidence in the economy is prevented from building.

 

The salience of the secondary, confidence-based, effect is building. The market has begun to heavily price a before-year-end rate hike from the Bank of England as a base case scenario. Meanwhile, the Federal Reserve Bank has heavily signalled its intention to taper its bond purchasing programme, quantitative easing. Moreover, the European Central Bank is already looking to start its sequenced monetary policy tightening procedure. The global move towards a tighter monetary policy could potentially see Australia falling behind, with expectations stagnating around the RBA continuing to hold the interest rate until the fourth quarter of next year.

 

At 4:30am BST a spike in the value of the Pound Sterling against the Australian Dollar is clearly visible. This event is whilst markets price out the upside risk of an interest rate hike. This is then seen to deteriorate throughout the day, which can be attributed to Pound Sterling weakness, most apparent when the Aussie Dollar is compared to the US Dollar/Pound and Euro/Pound currency crosses. By market close, the trading value of the Australian Dollar was roughly where it has started at the beginning of the day.