U.S. monetary policy
As we had previously suggested was possible at its 20/21 September meeting, the Federal Reserve announced that it would indulge in a so-called ‘Twist’ operation-selling $400 bn of its holdings of under 3-year Treasuries and buying $400bn of 6-30 year maturities in an attempt to lower long-term yields - given their direct correlation with mortgage rates and also the discount rates used by commercial enterprises to evaluate the viability of long-term business ventures.
The post-meeting statement noted “continuing weakness in overall labour market conditions” and “only a modest pace” of growth in consumer spending and repeated the committee’s belief that inflation will “settle...at levels at or below those consistent with the Committee’s dual mandate”. As a result, 30-year yields fell below 3.00 percent - one of our ’10 Outrageous Predictions for 2011’, made last December.
Our feeling continues to be that risk markets will continue to be underwhelmed by the Fed’s actions and that ‘Operation Twist’ is but the next step in an inexorable move towards what we long ago dubbed ‘QE Infinite’- repeated QE’s with diminishing returns.
The next instalments in the saga will be QE3 - probably in Q1 2012, as the economy fails to revive and stock markets languish. A reduction in the rate the Fed pays banks on excess reserve holdings from 25 bp to 10 bp is also highly likely within that timeframe, in a desperate attempt to encourage banks to lend to the real economy.
Eurozone monetary policy
As predicted in our Q3 Outlook, the ECB duly raised its main refinancing rate to 1.5 percent at its July meeting and, at the time, markets expected that this was the beginning of an inexorable march higher in rates over the coming months and years. However, unfortunately the world economic situation in general and that of the Eurozone in particular, has exhibited a marked deterioration since then.
In addition to the general gloom which has descended upon the world’s largest economy, as discussed above, the main developments in the Eurozone have been as follows:
• July saw the announcement of a further package of measures from the European Council aimed at easing the Greek crisis and halting contagion into Spain and Italy. As has become the norm over the last 18 months the market was at first reasonably impressed, but enthusiasm quickly evaporated. This was principally because the European Financial Stability Facility (although newly authorised to intervene in the secondary bond markets of all European Monetary Union countries if the European Central Bank judged that ‘exceptional financial market circumstances’ posed a threat to financial stability) was not increased in size, and so would be completely inadequate should it become necessary to support Spain and Italy.
• Therefore, it finally dawned on the markets that the only solution that would bring an end to the debt crisis was a fiscal union, and speculation quickly arose that the natural precursor to this, the issuance of Eurobonds for which EZ governments would be jointly and severally liable, was now on the cards.
• Germany quickly and resolutely made it clear that it would not support the issuance of Eurobonds and the German Constitutional Court ruling on 7 September also underlined this position.
• A surprise fall in EZ core CPI in July from 1.6 percent to 1.2 percent, a level maintained in August.
• Weak business sentiment surveys.
Given the climate created by all of the above, it came as no surprise when fear did indeed spread to Spain and Italy (taking their 10-year bond yields well above 6 percent), so the ECB had to reluctantly revive its bond buying programme or securities markets programme (SMP) in the face of a divided ECB Governing Council, with the Bundesbank implacably opposed to the measure.
It therefore also came as no surprise when ECB President Trichet adopted a much more dovish tone at the news conference following the 8 September meeting of the Governing Council. Although it was apparently too embarrassing to reverse the recent rate hikes so soon, he made it clear that further increases were now firmly off the agenda and left the door wide open for decreases in the near future.
We now expect that, at the very least, before year-end the ECB will reintroduce the provision of unlimited, fixed rate, long-term liquidity to banks, thus flushing the system with liquidity and forcing actual market rates lower than the refinance rate, if it chooses to keep this at 1.5 percent to save face, but probably also a reduction in same back to 1 percent and in the deposit rate from 0.75 percent to 0.25 percent. If the real economic decline accelerates, or the EZ debt crisis spirals out of hand, or interbank funding dries up, then these moves could come very quickly and we may even see the refinance rate reduced to 0.5 percent.
Japanese monetary policy
Mindful of the worsening economic situation, The Bank of Japan increased its Asset Purchase Programme by Yen 10 trn at its meeting on 4 August. The measure was also no doubt intended to reinforce that day’s foreign exchange market intervention, aimed at weakening the yen. Although this achieved initial success, with the yen dropping from approx 77.00 to the dollar to 80.24 on the day, global financial turmoil has since fostered investors’ continued search for safe-havens, quickly taking the dollar back below 77.00.
We maintain our call for unchanged Japanese rates throughout 2011, and indeed also through 2012, and feel further quantitative easing is very likely.
UK monetary policy
The minutes of the 8 September Bank of England’s Monetary Policy Committee (MPC) meeting revealed that the decision to leave rates unchanged at 0.5 percent was of course unanimous. This came as no surprise to us or to the markets and, although Adam Posen remained the only member calling for increased asset purchases, (voting again for an additional £50 bn), “some” other members also moved towards QE2 - “This meant that the balance of risks to inflation in the medium term was likely to have shifted further to the downside. Most of these members thought that it was increasingly probable that further asset purchases to loosen monetary conditions would become warranted at some point”
As a result, we now feel that QE2 before Christmas is extremely likely, and rates are certainly not going to rise before 2013.
As we had previously suggested was possible at its 20/21 September meeting, the Federal Reserve announced that it would indulge in a so-called ‘Twist’ operation-selling $400 bn of its holdings of under 3-year Treasuries and buying $400bn of 6-30 year maturities in an attempt to lower long-term yields - given their direct correlation with mortgage rates and also the discount rates used by commercial enterprises to evaluate the viability of long-term business ventures.
The post-meeting statement noted “continuing weakness in overall labour market conditions” and “only a modest pace” of growth in consumer spending and repeated the committee’s belief that inflation will “settle...at levels at or below those consistent with the Committee’s dual mandate”. As a result, 30-year yields fell below 3.00 percent - one of our ’10 Outrageous Predictions for 2011’, made last December.
Our feeling continues to be that risk markets will continue to be underwhelmed by the Fed’s actions and that ‘Operation Twist’ is but the next step in an inexorable move towards what we long ago dubbed ‘QE Infinite’- repeated QE’s with diminishing returns.
The next instalments in the saga will be QE3 - probably in Q1 2012, as the economy fails to revive and stock markets languish. A reduction in the rate the Fed pays banks on excess reserve holdings from 25 bp to 10 bp is also highly likely within that timeframe, in a desperate attempt to encourage banks to lend to the real economy.
Eurozone monetary policy
As predicted in our Q3 Outlook, the ECB duly raised its main refinancing rate to 1.5 percent at its July meeting and, at the time, markets expected that this was the beginning of an inexorable march higher in rates over the coming months and years. However, unfortunately the world economic situation in general and that of the Eurozone in particular, has exhibited a marked deterioration since then.
In addition to the general gloom which has descended upon the world’s largest economy, as discussed above, the main developments in the Eurozone have been as follows:
• July saw the announcement of a further package of measures from the European Council aimed at easing the Greek crisis and halting contagion into Spain and Italy. As has become the norm over the last 18 months the market was at first reasonably impressed, but enthusiasm quickly evaporated. This was principally because the European Financial Stability Facility (although newly authorised to intervene in the secondary bond markets of all European Monetary Union countries if the European Central Bank judged that ‘exceptional financial market circumstances’ posed a threat to financial stability) was not increased in size, and so would be completely inadequate should it become necessary to support Spain and Italy.
• Therefore, it finally dawned on the markets that the only solution that would bring an end to the debt crisis was a fiscal union, and speculation quickly arose that the natural precursor to this, the issuance of Eurobonds for which EZ governments would be jointly and severally liable, was now on the cards.
• Germany quickly and resolutely made it clear that it would not support the issuance of Eurobonds and the German Constitutional Court ruling on 7 September also underlined this position.
• A surprise fall in EZ core CPI in July from 1.6 percent to 1.2 percent, a level maintained in August.
• Weak business sentiment surveys.
Given the climate created by all of the above, it came as no surprise when fear did indeed spread to Spain and Italy (taking their 10-year bond yields well above 6 percent), so the ECB had to reluctantly revive its bond buying programme or securities markets programme (SMP) in the face of a divided ECB Governing Council, with the Bundesbank implacably opposed to the measure.
It therefore also came as no surprise when ECB President Trichet adopted a much more dovish tone at the news conference following the 8 September meeting of the Governing Council. Although it was apparently too embarrassing to reverse the recent rate hikes so soon, he made it clear that further increases were now firmly off the agenda and left the door wide open for decreases in the near future.
We now expect that, at the very least, before year-end the ECB will reintroduce the provision of unlimited, fixed rate, long-term liquidity to banks, thus flushing the system with liquidity and forcing actual market rates lower than the refinance rate, if it chooses to keep this at 1.5 percent to save face, but probably also a reduction in same back to 1 percent and in the deposit rate from 0.75 percent to 0.25 percent. If the real economic decline accelerates, or the EZ debt crisis spirals out of hand, or interbank funding dries up, then these moves could come very quickly and we may even see the refinance rate reduced to 0.5 percent.
Japanese monetary policy
Mindful of the worsening economic situation, The Bank of Japan increased its Asset Purchase Programme by Yen 10 trn at its meeting on 4 August. The measure was also no doubt intended to reinforce that day’s foreign exchange market intervention, aimed at weakening the yen. Although this achieved initial success, with the yen dropping from approx 77.00 to the dollar to 80.24 on the day, global financial turmoil has since fostered investors’ continued search for safe-havens, quickly taking the dollar back below 77.00.
We maintain our call for unchanged Japanese rates throughout 2011, and indeed also through 2012, and feel further quantitative easing is very likely.
UK monetary policy
The minutes of the 8 September Bank of England’s Monetary Policy Committee (MPC) meeting revealed that the decision to leave rates unchanged at 0.5 percent was of course unanimous. This came as no surprise to us or to the markets and, although Adam Posen remained the only member calling for increased asset purchases, (voting again for an additional £50 bn), “some” other members also moved towards QE2 - “This meant that the balance of risks to inflation in the medium term was likely to have shifted further to the downside. Most of these members thought that it was increasingly probable that further asset purchases to loosen monetary conditions would become warranted at some point”
As a result, we now feel that QE2 before Christmas is extremely likely, and rates are certainly not going to rise before 2013.
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