Headwinds outnumber tailwinds in the US economy, and only a small string of poor US figures could tip control in the Fed back to the doves. So says Christopher Vecchio of DailyFX.
In the interview below, Vecchio discusses the situation of monetary policy, the bigger issues facing Spain, the key for China and the Australian dollar and more.
Christopher Vecchio is a currency analyst for DailyFX. With a background in political science and law, he focuses on the interrelationships between geopolitical events, macroeconomic trends, and market reactions. Also an active trader, Christopher monitors the markets around the clock. Expertise: News events, market reactions, an macro trends.
1. Bernanke recently provided bearish comments. Did he want to justify the current projections of a low interest rate until late 2014? Or did he hint about QE3 coming relatively soon?
The Federal Open Market Committee made its pledge to keep rates low through 2014 back in January, so for Chairman Bernanke to only start defending his position now seems obtuse. Considering the timing of his comments – nearly two weeks after the Federal Reserve’s March 13 meeting – it seems to me that he is trying to quell fears that another round of quantitative easing is off the table. This is the biggest concern for the market now, with the FOMC minutes provoking a selloff in higher yielding currencies and risk-correlated assets in favor of the U.S. Dollar. Will there be more QE? I think so even though I don’t agree with the policy (I’m ardently against it). Chairman Bernanke needs empirical economic evidence to ease further, something he doesn’t have now, so he is in wait-and-see mode. The headwinds to the U.S. economy outnumber the tailwinds, and it will only take a small string of poor U.S. data ahead of the upcoming FOMC meetings to have the Fed’s doves ruling the roost once more.
2. The European debt crisis took a break from Greece, but seemed to have crossed the Mediterranean to land in Spain. Is there a real danger of Spain needing aid? Or is it “only” about to suffer from a deep recession?
Spain is in serious trouble and this backburner concern has graduated to the limelight. Spain’s biggest two problems are their housing and labor sectors. The government revealed earlier today that Spain’s national debt will jump to approximately 80 percent of GDP this year. This comes as Spanish growth is forecasted to contract by 1.7 percent this year. Will the austerity measures help reduce the deficit? Perhaps, but if institutions fail in this process their debt will be passed onto the government. Why is this a concern for Spain? Private sector debt is about 240 percent of GDP. If financial conditions deteriorate, Spain could be headed towards the situation Ireland is in, in which they have to nationalize several major institutions with the government absorbing their debt, thereby making the sovereign debt crisis worse. Spain is the key cog in the Euro-zone’s austerity measures as if Spain needs a bailout, contagion will wreak havoc on investor confidence, sending yields across Europe soaring, making the crisis worse.
3. The Bank of England has the never ending dilemma between battling inflation and supporting the wobbling economy. Will they act in either direction in the upcoming months? Or wait for things to lean to a specific direction?
Bank of England policymakers, like FOMC policymakers, have indicated that they believe that inflation will settle back towards its medium-term target of 2 percent as growth continues to strengthen slowly. Along these lines, the BoE has indicated that it will normalize policy as the recovery stabilizes. The only way for central banks to normalize their policy without risking a liquidity shock to the market would be to give as much slack as possible during the deleveraging process. The BoE has recently insinuated that it will follow the path the Fed is: raise rates first, and then unwind the balance sheet. This to me makes the most sense when Western central banks begin to deleverage given the fragile recovery taking place across most of the world’s major economies. As rates are lifted, more QE can be used to sterilize the rate hikes and ensure that liquidity continues to flow. In the other scenario, with rates already at or near historic lows, if the central bank unwinds its balance sheet first, it can’t lower rates any further, meaning that it would need to induce more QE and thus any policy change is neutralized.
4. China’s official and unofficial PMIs are drifting apart. Is the price of the Australian dollar already reflecting the darker scenario seen in the unofficial numbers?
The Australian Dollar has definitely been hit by poor Chinese data the past few weeks. As Australia’s largest two-way trading partner, concerns over a slowdown in China wreak havoc on Australian growth prospects. The Chinese PMI manufacturing figure for March was better than expected but it is worth noting that the March figure is historically 3.2 points higher (due to seasonality). Is the Chinese economy as weak as these figures have suggested? The key for me are the inflation data due next week. If growth prospects are indeed falling as quickly as they appear, a stronger Chinese CPI figure will handicap policymakers and stir worries of relative stagflation in Chinese. A softer than expected CPI figure due next week would certainly help the People’s Bank of China in its fight to stabilize a slipping economy and thus the Australian Dollar.
5. Japan’s fresh Tankan figures don’t look too encouraging. Will Japanese authorities consider more efforts to weaken the yen in the new fiscal year?
I don’t think Japanese policymakers are done intervening in the market. We saw how the market reacted earlier when the Fed hinted that QE3 is a remote possibility: U.S. Treasury yields went up, thereby increasing the yield the U.S. Dollar has against the Japanese Yen. But what happens if the Fed announces more QE in the coming months? The USDJPY would start to tumble. If the Fed steps up easing efforts, I imagine the Bank of Japan will move to weaken the Yen further. The line in the sand, if you will, is the 80.000 exchange rate – a move by USDJPY below this will prompt some sort of intervention (verbal or monetary). When 2012 is said and done, we maintain a 90.000 target for USDJPY for now but if the U.S. economy continues to strengthen and Asian and European growth prospects brighten, a move towards 95.000 or 100.000 wouldn’t be out of the question.
— Written by Christopher Vecchio, Currency Analyst
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