Central Banks, Surprises and Otherwise

In our age of transparency, monitoring the signals from the major central banks is not a full time occupation. Wall Street used to hire people whose sole job was to mine the data and official comments for clues into policy. Such people now are among the endangered species. When one wants to contemplate the Federal Reserve’s next move, one can consult the Fed funds futures contract, where the accuracy of the front month contract is well known especially as an FOMC meeting draws near.

Other countries do not have a comparable contract to the Fed funds futures. The rubber band that ties 3-month money to overnight money is fairly elastic and less precise in deciphering expectations for policy. Moreover, the three-month futures contracts, like Euribor and short-sterling futures, are best understood not as 3-month money, but really a forward rate agreement (FRA). If one were to take delivery of a March Euribor futures contract, one would receive a three month time deposit for one million euros. As we are in the middle of January, the true comparison is the three month rate in 2 ½ months time.

Not only does this complicate extrapolating policy from looking at the three-month futures contracts, but it is even more difficult than that. If one were to take delivery of a 3-month time deposit, one would want the interest rate to reflect the risk of a change in policy during the tenure of the time deposit. That is to say that, in our example, the March Euribor futures should reflect some part of the expectations of ECB policy in Q2.

Bank of England Governor Mervyn King, once quipped that interest rate policy should be “boring”, yet in the past 18 months, UK interest rate policy has been anything but. Back in the summer of 2005, over his objections, the monetary policy committee decided to cut rates. I cannot recall another major central bank where the governor was out-voted. Last August the BOE caught the market wrong footed when it hiked rates. The November 2006 hike was largely anticipated, but yesterday’s rate hike again surprised the market. With weakness in domestic demand, manufacturing and exports, the consensus had been for the BOE to stand pat awaiting more data. The market had discounted a hike next month.

Methodologically BOE officials offer little guidance to the market about MPC intentions. The Committee’s willingness to act without preparing the market stands in stark contrast to other central banks, including the European Central Bank. The ECB began the current rate hiking cycle in Dec 05. It was well telegraphed and since last spring, ECB President Trichet has used certain phrases that have become a tell, like a guy at a poker table who plays with his wedding ring when he has a good hand. The key word that was noticeably missing at Thursday’s press conference was “vigilant”. This had been a word that Trichet used to signal a rate hike at the next meeting in the past. Consequently the market realized that a February hike, which the consensus had previously assumed, was now less likely. At the same time, Trichet made it clear that the rate hiking cycle was not complete.

The market appears to have simply shifted its expectations for the next hike out to March. The March Euribor futures contract barely reacted. On a weekly close basis, the contract has been essentially unchanged at 96.08. This implies a 25 bp rate hike is fully discounted and there is a high probability of another hike here in H1. Looking at the entire strip of Euribor futures contracts suggests that the market has a strong presumption that the cycle peaks at 4%.

The failure of Trichet to signal a hike next month did not really change market expectations much. The Bank of England’s surprise was by far more significant. The market has responded by assuming that Thursday’s rate hike comes in addition to the other two rate hikes that were previously discounted. The March short-sterling futures have fallen 25 bp this week as has the June contract. The British pound has been bid higher on this shift in interest rate expectations, rallying 1.5% against the dollar. It rallied more than 2% against the euro to reach its best level in more than 2 years.

The Bank of Japan meets on January 17-18 and regardless of what they decide it will be a surprise. There had previously been a strong consensus in favor of a hike, but that consensus has broken down in the face of a string of disappointing data and heightened political pressure from current and former government officials. One news wire poll found 19 of 35 expect a hike, while another newswire reported about 2/3 of those surveyed expected a hike. The press in Japan itself seems divided and this likely points to a division on the BOJ board itself. The March Euroyen futures contract offers little help here. It has closed at an implied yield of 0.68 bp for three consecutive weeks, which is also what it has averaged for the last 50 sessions.

The case for a rate hike is based on ideas that the economic recovery remains intact, despite a softer than expected third quarter. Japan’s growth is still heavily dependent on exports and new found confidence of a soft landing in the US economy, its most important foreign market—not only for exports but also for local production—should also, on the margins be favorable for Japan. In addition, from a strategic perspective, the BOJ might be feeling a sense of urgency to continue to normalize monetary policy so as to give it room to maneuver (without having to resort to an extraordinary measure, like zero interest rates) should the longest economic recovery since the end of WWII end. Moreover, with an eye toward H2, fiscal policy is expected to be tightened. A combination of tighter monetary and tighter fiscal policy would provide a formidable headwind for the economy.

However, given the political pressure that has been brought to bear, Bank of Japan officials may want great cover, in the form of stronger economic data, before they raise rates again. A couple of BOJ officials have hinted that consumption may have picked up in Q4 after a simply dismal Q3, which may have been distorted by unseasonable weather patterns. The government is set to release Q4 GDP in the February 12-15 period and it does seem reasonable to expect that growth picked up from the 0.8% annualized rate posted in Q3. Such a report might provide a more favorable environment for the BOJ to hike at its next meeting on Feb 20.

The lack of a clear consensus warns of a currency market reaction regardless of what the BOJ decides at the end of next week. Ahead of it though, prudence warns that speculative players may reduce short yen positions. It would not be surprising then to see the JPY121 area cap the dollar rally - this is near where, incidentally, stops and options have been reportedly struck - and for the greenback to ease toward JPY119-JPY119.30.

Ironically, it could very well turn out that a rate hike is more yen negative than standing pat. The thinking here is that the failure to raise rates will simply see participants shift the focus to February, while a rate hike gets it out of the way. And at what would then be 50 bp, its overnight interest rate would still be low in relative and absolute terms.