Central Bank Comments Change the Landscape


Last week may prove to be the point at which we look back and pinpoint where Central Banks around the world decided the time for zero interest rate policy (ZIRP) must end (excluding the US who have already moved away from this). But we’ve had many false starts before, and certainly in the UK there’s been enough that I have almost stopped believing it may ever happen. So is this time any different?

 

The only thing that has changed with certainty is that there is no longer any real consensus in the market. Central Banks on the whole have spent the last number of years trying to provide clear forward guidance. This has led to the absurd practice of analysing every word of every Central Bank statement.   If they had previously said “very likely” and changed this to “likely” this would send markets into freefall!  However last week we saw the ECB, Bank of England and Bank of Canada all provide surprise u-turns on previous commentary.

 

Less than two weeks ago, Mark Carney stepped out to say that “now is not the time to raise rates” only to walk this back last week by stating that, should business investment continue to pick up pace (amongst many improving factors), then “some removal of monetary stimulus is likely to become necessary.” This sent GBPUSD above $1.29, and before the end of the week it broke through $1.30. Carney may be realising the mistake he made last summer when he pre-emptively cut rates by 25 basis points, a move which was probably not required, and has added more fuel to the fire with respect to the asset inflation issue.

 

Picture1

 

Meanwhile, the Bank of Canada’s Stephen Poloz has totally reversed his stance in a few weeks which caught the market off guard. Poloz indicated that the emergency rate cuts in 2015, implemented due to the oil price shock, should now be reversed.  As such, the market has moved from expecting two rate rises in two years to expecting two before October, and there is a 65% likelihood that the first one will come as soon as mid-July.  This has had real impact on CAD pairs, strengthening the loonie considerably since early June, with USDCAD now trading at $1.30.

Picture2

 

Data from Bloomberg

 

Finally, the ECB’s Mario Draghi got caught out with misinterpretation of a speech made last week, which is always a risk when every statement is analysed more than necessary, as highlighted above. Markets interpreted his comments as a statement of intent to start reversing the quantitative easing (QE) program, despite the fact that two weeks earlier he made a particularly dovish speech, which led to a large selloff of EUR denominated bonds.

 

In reality, it is likely that the markets are overestimating the increase in hawkish bias.  July is probably too soon for the Bank of Canada to raise rates, and I think the market is massively overestimating how many and how fast rate rises will be. Poloz’s statement suggested that he would reverse 2015’s rate cuts which would increase the level back to 1.0%. This is feasible and the economy could likely cope with this, but any further than that and he runs a real risk of triggering an event in the housing market. But these increases are going to be slow to ensure the market adjusts after each one.

 

Similarly, in the UK and Europe the current anticipation of rate rises is not likely to be fulfilled, at least to the extent that the market is currently pricing.  However, the expectation of rises, and the resulting currency strength is a trend we see likely to continue to build in the short-term.

 

What would be much more beneficial, and has even been hinted at by both Draghi and Carney, is that instead of a rate rise they would taper QE instead. This concept has significant merit. Increasing rates without reducing the artificially high amount of debt in the economy (£435 billion in the UK and over EUR 1 trillion on the continent) will compound the effect of the rise and potentially cause unintentional damage. It is debated how such a QE reversal would occur in practice, particularly the choice of which bonds to return to the market and how quickly this could occur without causing immediate shocks to the market. In any case it would leave interest rate hawks wrong-footed again, and currency forward curves requiring some dovish adjustment.

 

Author: Andrew Stewart

 



 

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