Q2 Monetary Policy: Major central banks

US
On such subtle changes in the utterances of the Federal Reserve do such enormous consequences for the global economy rest. Former Chairman Greenspan, who always seemed to delight in making Delphic, almost indecipherable speeches, would have greatly admired the last post Federal Open Market Committee meeting statement, released on March 13. Yet the seemingly innocuous phrases therein caused a great upheaval in the bond markets, notwithstanding the virtually imperceptible changes in their implication from the previous meeting.

So what were these earth-shattering changes in FOMC language between the two meetings? Overall, although the FOMC continues to see “significant downside risks” to the economy, it did acknowledge that “strains in global financial markets have eased” and that it expects “moderate” instead of “modest” growth over the coming quarters.

Regarding the global picture, the phrase “notwithstanding some slowing in global growth” disappeared. The members also observed that unemployment has declined “notably” recently, and that going forward they expect it to decline “gradually”, rather than “only gradually”.

Finally, in an attempt to calm nerves over energy prices, they say that “inflation has been subdued in recent months”, “although prices of crude oil and gasoline have increased lately”, and they expect “the recent increase in oil and gasoline prices will push up inflation temporarily”, however “subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.”

Not really calculated to set the blood racing, one would have thought, but in fact it was enough to initiate a sharp move higher in Treasury Bond yields (40 basis points in the 10-years) and to advance expectations of the first hike in the Fed Funds rate from 2014 into 2013.

So will we look back and see March 13 as a massively important turning point? Was this the day we realised that that arch-doves Bernanke and Dudley will have trouble persuading their middle-ground colleagues like Pianalto to vote for further Quantitative Easing (QE)? As we highlight throughout this publication, this is yet another balancing act - the irrepressible animal spirit of the US economy does seem to be reasserting itself, and the FOMC must be tempted to breathe a sigh of relief and turn its mind towards the eventual need to tighten. No central banker wants to go down in history as the one that caused inflation to get out of hand - the ultimate crime.

On the other hand, the FOMC knows that Europe rests on a knife-edge; not for them the naive confidence that the market has developed following the European Central Bank’s covert QE; it knows this is only yet more ‘pretend and extend’, and unless peripheral Europe keeps its fiscal house in order, even in the face of mass street protests as unemployment soars, then the debt crisis will be back with a vengeance in the second half of the year. There is also a worrying degree of automatic fiscal tightening built into the US landscape in early 2013 - will the Bush era tax cuts be extended again? Failure of the Super-Committee to agree on deficit cuts means that $1.2 trillion of cuts are due to be imposed automatically in 2013.

It is hard to escape the conclusion that this leopard won’t change its spots so quickly and that the market has got ahead of itself in driving Treasury yields higher and bringing forward the date for Fed Funds hikes. We’d still expect to see more QE before the end of the year - the ‘Bernanke Put’ is alive and well and ready to spring into action in either of three negative scenarios: 1) growth stalls below 2 percent, or 2) stock markets collapse by more than 20 percent, say, or 3) 10-year yields climb over 3.0 percent. Number 1), at least, seems highly probable.

Whilst it actually would make little or no economic difference, we’d say there’s a 50 percent chance the Fed opts to ‘sterilise’ this QE3 by draining the reserves so far created back from the banks. This would be almost purely presentational, except one might argue that it could forestall the bull run in commodities that could ensue from yet further unsterilised QE, and which would serve to depress the economy.

Eurozone
‘Once upon a time there was a German Princess called Angela - she kissed a lot of frogs and eventually one of them turned into an Italian Prince called Draghi with a huge balance sheet in Frankfurt - they lived happily ever after’

So goes the story of the ECB’s apparently hugely successful Long Term Refinancing Operations which came in two batches (in December 2011 and February 2012), giving the Eurozone’s banks the three-year funding they desperately needed. They in turn went straight out and bought the distressed bonds of their mother countries and the debt crisis abated, with bad banks financing bad governments and crowding out private capital.

To good to be true?  Pretend and extend gone mad? We think so.

Following the Greek ‘solution’, attention will ultimately turn to Portugal and then its far more important neighbour, Spain. Suffice it to say the omens are not good, with Spain already attempting to find some wriggle room within the EU’s Fiscal Compact.

For its part, the ECB feels it has earned a ‘rest’, following the last few months’ vigorous endeavours. To quote from the March ECB meeting, they saw ‘signs of stabilisation’, an upgrade on February’s “tentative signs of stabilisation”, and observed somewhat pointedly, “the urgent need for governments to make further progress towards restoring sound fiscal positions and implementing the structural reform agenda”, and, “the ball is now in the court of governments”.

Given our prognosis for the European economy, it seems likely that the ECB will eventually have to cut its main Refinance Rate again, although the decline in interbank lending rates due to the sea of LTRO liquidity may allow them to escape having to do this. This would certainly please the Bundesbank, for instance. We put only a 25 percent chance on a rate cut in Q2, but 50 percent before the end of 2012.

In regards to further non-standard measures, given the Bundesbank President Weidmann’s publicly voiced concerns, we think the hurdle for further LTRO’s is now set very high - an imminent meltdown of the Eurozone’s banking system, as it was likely in December, would be a necessary condition for this to be even considered.

Japan
In the face of persistent yen strength, the Bank of Japan finally acted decisively to pump more money into the economy, increasing its Asset Purchase Program by 10 trillion yen in February (to be used to purchase long-term Japanese Government Bonds) and simultaneously introducing a 1 percent inflation goal. It followed up at the March meeting by announcing expansion of its Growth-Supporting Fund Facility - cheap long-term loans to banks that are then expected to extend more finance to the corporates who really need it. To quote the BOJ, “the role played by private financial institutions, as entities that provide risk money to the corporate sector and therefore support innovation, is very important”.

What next? Having nailed its colours to the mast, we don’t expect the BOJ to shrink from further QE if necessary. What defines necessary? Well it now has an explicit inflation target, so that will be easy to track.

Just as important is the equally visible international value of the yen. The BOJ was palpably under intense political pressure to act and this would undoubtedly resurface if USD/YEN, for instance, dipped below 78.00, say. Look for further increases in the Asset Purchase Program and for lengthening of maturity of JGB’s purchased, as the next measures.

UK
Chancellor of the Exchequer Osborne stuck to Plan A when he delivered the annual budget on March 21 - in other words, to balance the primary budget by 2016.

The fact that the European crisis seems to have abated, (albeit temporarily in our view), would argue for ‘steady as you go’ on the part of the Bank of England i.e. no further increase in its £325bn programme of Quantitative Easing, (or the Asset Purchase Programme as the BOE  calls it), but given the government’s strategy of rapid fiscal consolidation, and given the fact that the economic landscape is still characterised by substantial spare capacity, we would expect to ultimately see more QE in H2, as the European situation deteriorates again and/or the US economy slows down.

Switzerland
The latest Monetary Policy Assessment, released after the March 15 meeting of the Swiss National Bank strikes a distinctly dovish tone.

The statement says, “downside risks for price stability could re-emerge … if the Swiss franc does not weaken further, as expected”. The SNB also “stands ready to take further measures at any time” and, perhaps fearful that the Euro 1 trillion of money injected by the European Central Bank’s LTRO’s might weaken the Euro, the SNB was quick to fight back by emphasising that it “will continue to maintain liquidity on the money market at an exceptionally high level”.

With its expected path for inflation revised down since the December meeting, and with a return to positive territory only expected in Q1 2013, the stars seem to be moving into alignment for a higher re-peg of the Swiss Franc versus the Euro in Q2 2012, and we would estimate a 50 percent chance of this occurring.

Fixed Income Markets
Given our over-arching view that the ECB’s LTRO’s have just bought time, and don’t represent anything that could be referred to as a lasting solution, it will come as no surprise that we view the recent tendency for investors to shun safe-haven fixed income instruments, e.g. US Treasuries, Bunds and UK Gilts, as a temporary phenomenon.

Indeed, as mentioned above, there is a self-correcting mechanism that will come into play should US yields rise too far. We estimated that 3 percent in the 10-year yield may represent a Rubicon for the Federal Reserve, such that it would instigate QE3 should the market spurn Treasuries to that extent.

This, therefore, helps us define a probable range in yield for the year in 10-year Treasuries; 3 percent on the topside, and we could see a revisit of the 1.75 percent lows, should the European situation deteriorate disastrously. Purchases of the 10-year at 2.75 percent yield, say, would therefore seem to represent a good risk/reward. Similar trajectories can be envisaged for Bunds and Gilts. As the ultimate solution to the Euro crisis will inevitably involve more German contributions, one suspects US bonds may outperform as the year unfolds.

See the entire Saxo Bank Q2 2012 Outlook report in PDF version.

See previous Saxo Bank Quarterly Outlooks.

See a video with Saxo Bank's Chief Economist Steen Jakobsen on the Q2 Outlook.