Bernanke faces the press again

Now that the Greek government has passed its first test of the next seven days (it won a confidence vote with a majority of five in the 300-seat Parliament early this morning) the focus shifts to the Federal Reserve and Ben Bernanke’s second ever press conference later today.

The markets have moderated slightly after a strong start to the week; EURUSD is below 1.4400 and European stock indices are a touch lower. The dollar index is flat as we await Bernanke and the anticipated announcement of the end of QE2.

Even though the economic data points to a mid-year slowdown in the US, we don’t think that QE3 will be forthcoming. However, if the economy doesn’t bounce back by the autumn then we wouldn’t rule out further stimulus, but we aren’t at this stage yet.

Right now we think the Fed will bide its time, maintaining the size of its enormous balance sheet and only embarking on a very moderate form of monetary policy normalisation towards year-end and only if the economic conditions start to perk up and the unemployment rate falls below 8 per cent. At its last meeting in April the Fed looked at various ways to normalise policy. The most likely scenario is that the Fed will firstly stop reinvesting the proceeds of agency securities, then it will stop reinvesting (or rolling over) its Treasuries. Only after this will the Fed start to hike rates.

All of this means that the US is likely to remain a low interest rate environment for some time yet. While some have called for a collapse in risky assets on the back of the end of QE2, we would argue against this. The size of the Fed’s balance sheet is inversely correlated with the dollar, so for as long as the Fed holds onto the assets it owns then the dollar will struggle to convincingly stage a rebound. Stocks and commodities will be boosted from two factors: firstly, they tend to rally when the dollar is low and secondly, when Treasury yields are low investors will prefer to own higher-yielding assets like emerging market debt, equities and of course commodities.

The caveat is the Eurozone sovereign debt crisis. This is far from over. As mentioned above the Greek PM passed the easier of its two tests earlier. Today the Socialist party will hold a vote on the EUR28bn of cuts and EUR50bn of privatizations necessary to secure the next tranche of bailout funds. Then it has a colossal task of getting this package through Parliament (i.e. getting the opposition on board who have been critical of the government’s handling of the crisis so far) during a vote on 28th June.

The EU has tried to sweeten the harsh austerity measures with the promise of investment grants if Greece implements its fiscal consolidation plans. While this is necessary to promote growth in the debt-ridden state, there is still a lot of event risk over the next week, and we may yet see Greece descend into a disorderly default. Either way, the harsh fact is that Greece has borrowed too much that it can’t afford to pay it all back, so either Germany pays its debts back or there will be some form of default/ haircut later this year or even in 2012.

Greek bond yields are higher today. It’s also worth keeping an eye on the spread between Italian and Spanish bonds versus German bund yields. The Spread with Italy is close to highs reached back in November. Italy is the third largest economy in the Eurozone and if it gets hammered by the bond vigilantes like Greece, Portugal and Ireland then it is hard to see how the Eurozone could afford to bail it out.

Further tensions in Greece may cause this spread to hit fresh highs, which is euro negative. The last time the Italian bond spread with Germany spiked, EURUSD rose to 1.3000.

The pound is much weaker today after the minutes of this month’s BOE meeting were released this morning. The Monetary Policy Committee (MPC) voted 7-2 to keep rates unchanged. The new policy member Ben Broadbent did not follow his predecessor Andrew Sentence and vote for a rate hike, instead he voted with the majority.

The tone of the minutes was fairly dovish. They noted that for most members the key downside risk was that growth would slow leading to inflation eventually falling below the target rate. So although inflation is running at more than double the target now, the MPC is willing to look through this “temporary” spike in inflation. Although some members were concerned with rising prices, the Committee sees little sign of higher CPI inflation feeding into wage claims”. This is a key condition before the MPC will raise rates. So slow wage growth supports the BOE remaining on hold. The minutes also noted that the Eurozone sovereign tensions had the potential to hurt demand, so while that crisis rages on a rate hike is unlikely in the UK.

The market is not expecting the BOE to raise rates until Q2 2012. This is weighing on sterling, and GBPUSD is below 1.6150 at the time of writing. However, that is a long time to remain on hold, and even those on the MPC who voted to keep rates unchanged said there was a risk that inflation pressure could have second round effects in the future. So we are back to data watching. Signs of a pick-up in core inflation in the UK, which is already at an elevated 2.9%, would spur rate increases sooner rather than later, so there is a chance the market has got ahead of itself with pricing out rate hikes from the BOE.

Ahead today, the Fed will dominate matters. A dovish tone is likely to keep pressure on the dollar, which may support risky assets. The Norwegian Central Bank will also announce interest rates at 1300 BST/ 0800 ET, it is expected to remain on hold.

Source: Forex.com

22.06.2011