Sunday, November 8, 2009

FX Briefing : Central Banks Maintain Expansionary Stance

  • Fed: Interest rates to remain at exceptionally low levels for an extended period
  • BoE: Asset purchase scheme extended again
  • ECB: Less liquidity needed due to financial market recovery
During the course of the week, the euro firmed somewhat against the dollar. After the ECB had concluded the series of central bank meetings, EUR-USD was around 1.4870 on Friday lunchtime, marginally stronger than a week ago.
This week, particularly important indicators were released in the US. The data painted a mixed picture, however. The ISM manufacturing index, for instance, improved from 52.6 to 55.7. This is the highest level since April 2006 and suggests that Q4 GDP growth could turn out to be as high as in Q3. For the first time in a long time, the employment components signalled an increase in jobs. The ISM non-manufacturing index told a different story, however: it rose less than the previous month, because the employment component, which was already weak, fell sharply to 41.1. Like the ADP private employment figures, the official labour market report for October is thus likely to show significant job losses again of about 200,000, but this would be still an improvement over September.

However, the main topic of discussion was not the economic indicators, but the central bank meetings in four big countries. First on the agenda was the Australian central bank: on Tuesday, it raised interest rates for the second time in four weeks from 3.25 to 3.5%. As this had been generally expected due to the improvement in the economic situation in Australia, it had little impact on the Australian dollar, which had already gained over a third against the US currency in the last 12 months. Australia is tightening monetary policy, because the downswing there was relatively moderate, and the sharp rise in commodity prices is now boosting the economy.
Australia's step did not have a signal effect on the central bank meetings in other large countries. On Wednesday, the Fed made it clear that no radical shift in monetary policy stance was on the cards. The FOMC confirmed its near-zero interest rate policy unanimously, and stated that interest rates were likely to remain low for a long time to come. Although the US growth rate rose to 3.5% in annualised terms in Q3, the assessment of the economy in the FOMC statement was not much better than in September. Although “household spending appeared to be expanding, it remained constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit.” Furthermore “businesses were still cutting back on fixed investment and staffing”.
The Open Market Committee also saw exceptionally low levels of the federal funds rate likely to be warranted for an extended period due to “low rates of resource utilisation, subdued inflation trends and stable inflation expectations.” Thereupon, EUR-USD jumped to its highest level since the beginning of the previous week.
The UK central bank (BoE) kept the bank rate at 0.5%, but increased the size of its asset purchase programme to £200bn. Given that GDP had continued to fall in the third quarter, however, markets had been expecting a larger expansion; the pound therefore rose slightly against the dollar and the euro. The BoE is expecting economic recovery to be slow; thus under-utilised resources will continue to dampen inflation for some time to come. In the short term, however, this will be offset by the impact of sterling's depreciation, according to the BoE. This could explain why the expansion of the asset purchase programme was less than widely expected.
The ECB also still considers its low interest rate of 1% to be appropriate. It is expecting GDP growth rates to be back in positive territory in the second half of the year, and the economy to recover at a gradual pace in 2010. However, it concedes that the outlook is uncertain, as a high number of the supporting factors will only have a temporary effect. Against this background, price stability is expected to be maintained over the medium term. According to Jean-Claude Trichet, however, less liquidity measures will be needed in future due to improved conditions in financial markets. He said that the governing council would make sure that the extraordinary liquidity measures taken would be phased out in time to counter effectively any threat to price stability. When asked at the press conference whether the ECB would prolong the 1-year tender in December, Mr Trichet merely replied that markets were not expecting this. Compared to the Fed, there was more emphasis on the necessity for a timely exit from the extraordinary measures, which boosted the euro again somewhat on Thursday afternoon.
There are some important eurozone indicators on next week's agenda. The advance estimates of GDP in Q3, for example: for Germany, we are expecting growth to have doubled compared to spring to +0.6% quarter-on-quarter. Unlike in Q2, growth in the eurozone as a whole will probably have picked up again too, albeit not quite as much, to +0.4%. Just like new orders, German production figures and the ZEW indicator are also likely to have improved further, which should continue to support the euro. The European currency is generally boosted by improved data, even if these come from the US, because they tend to increase risk appetite and demand for higher-yielding assets.
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