Monday, November 1, 2010

Fixed income market update

Federal Reserve to dictate EMEA monetary policy
Since August, we have strongly argued that the Federal Reserve’s stepping up of quantitative easing of monetary policy would have strong implications for monetary policy in the EMEA region, as we argued that the EMEA central banks would effectively have to postpone rate hikes and would have to “keep rates low for longer”. The outbreak of a global “currency war” has further escalated those pressures and it is now very clear that this realisation is spreading to most central banks in the region. Two monetary policy events this week clearly confirmed this - the publication of the Turkish central bank’s (TCMB) inflation report on Tuesday and the Polish central bank’s (NBP) rate decision on Wednesday. See our Flash Comments on the Turkish inflation report and the Polish rate decision.

Hence, both the TCMB and the NBP indicated that they were in no hurry to tighten monetary policy and both central banks explicitly mentioned stepping up of quantitatively easing from the Federal Reserve and the global “currency war” as a reason not to move ahead with monetary tightening in the near future. The reason for this is clear - should central banks like the NBP and the TCMB initiate a monetary policy cycle or just indicate
near-term monetary tightening then they would risk triggering an excessively speculative (and likely unsustainable) capital inflow, which could lead to their respective currencies becoming overvalued.

In that regard, it is worth noting that the Turkish lira is already quite overvalued, while the Polish probably is more or less in line with the long-term valuation. Last week, the Bank of Israel also publicly acknowledged that the Federal Reserve effectively dictates monetary policy for small, open economies with floating exchange rates - or at least the key monetary policy instrument is no longer (if it ever were) the absolute level of interest rates. Hence, the BoI paused in its monetary tightening cycle precisely because further monetary tightening would just lead to a strengthening of the shekel, which potentially could derail the recovery of the Israeli economy.

So what should central banks do when the Federal Reserve is “forcing their hand”? Or rather what will they do? We believe the answer to this question was delivered by the NBP and TCMB this week: rates will stay on hold as long as there is a risk that hikes would trigger an excessive strengthening of local currencies and that central banks will be looking at alternative measures to curb the negative side effects of low (potentially too low) policy rates and continued capital inflows seeking higher yields. Furthermore, the NBP’s action this week in hiking its reserve requirement for banks and thereby (moderately) tightening monetary and credit conditions without hiking rates, falls perfectly under these new alternative measures. The NBP has added that “measures aimed at preventing fast growth in foreign currency lending to households” would be important
for “macro-economic stability”. Said in another way - we can’t hike rates because that would simply lead to an excessive strengthening of the zloty, but we can prevent new credit bubbles by alternative measures to curb lending. Interestingly enough, in its inflation report the TCMB said exactly the same thing and hinted directly that it might hike the reserve requirement (as did the NBP) for banks to curb domestic credit growth.

In our view, this is a very clear signal to the markets that EMEA central banks are long away from rate hikes and that we are still in a “special situation” in which central banks will have to use alternative instruments in the fight to avoid economies overheating and new bubbles, while at the same time avoiding overvaluation of local currencies.

The growing arsenal of such alternative measures, as they are gradually creeping into the official statements of concerned central banks, range from higher reserve requirements - as discussed above - to incentivising the capital outflows while curbing the inflows. Exemplifying the latter measures in the wider EM universe, Brazil has taken early steps in raising the taxation on the foreign fixed income investments and South Africa is
embarking on a number of capital flow and foreign investment related regulatory undertakings.

The “problem” is probably most acute for the NBP, TCMB and BoI, as the Polish, Turkish and Israeli economies are all in relatively robust recoveries and there are some signs of (moderately) increasing  inflationary pressures. Although South Africa’s growth is not as robust as its peer countries and could so far be categorised as “jobless recovery”, it too is faced with similar challenges on the currency front. Central banks such as the Hungarian and the Czech probably need to be less worried as the slack in both the
Hungarian and the Czech economies is still relatively high.

From a market perspective, it is clear that the markets are increasingly realising that the EMEA central banks are in no hurry to start tightening monetary policy anytime soon. That said, even though we have argued that there would be good value in being positioned for lower yields - especially in Poland - we also acknowledge, even if we assume that rates will be on hold for a while in most EMEA countries, that there is also a risk that QE2 from the Federal Reserve has now been fully priced into the EMEA fixed income markets. By extension, if the Fed disappoints at next week’s FOMC meeting then EMEA yields could easily spike. This is an argument for maybe trimming positions for lower yields in the EMEA markets ahead of the next FOMC meeting. However, longer term there still are relatively strong arguments for expecting that yields will remain
relatively low in most EMEA countries. We therefore also continue to recommend being positioned for lower yields at the short end of the curve in Poland.

Czech and Romanian central banks on hold
We have two decisions on the agenda next week in the region - in the Czech Republic and Romania. We expect unchanged rates in both countries, but the environment in which the two central banks operate is rather different. Hence, in the Czech Republic we are in the midst of economic recovery, but there is still some slack in the economy and very low inflationary pressures, while the situation in Romania is one of deep - and maybe
deepening - economic crisis and very serious political and financial uncertainties.

The Czech central bank (CNB) should really not have much to worry about as inflation remains subdued and with core inflation even being close to zero. Furthermore, with the newly elected government implementing serious fiscal reform and domestic demand it is difficult to see any inflationary pressures developing in the coming one to three years.

Despite this, some CNB board members have been arguing in favour of rate hikes. We have long argued that this is somewhat misguided - especially as basically all our central banks in the region are on hold and the Federal Reserve is likely to step up quantitative easing next week. That said, we do not believe that there is a majority on the CNB board in favour of rate hikes next week even though we would not rule out that as many as three board members could vote in favour of rate hikes next week - despite the fact that we have a hard time understanding why these three board members are so much in a hurry to hike rates. However, this is unlikely to have any meaningful impact on the Czech FX and fixed income markets and as such the next rate decision is expected to be something of a non-event. The Czech policy rate is currently 0.75%.

In Romania, the central bank (BNR) has much more to worry about and the worries mostly concern issues that it has very little direct influence on, such as: serious political crisis, public finance worries, funding problems and massive exposure among households and corporations to foreign currency loans. These challenges seriously limit the BNR’s room for manoeuvre and therefore it is more or less a given that the BNR will have to keep its key policy rate, currently at 6.25%, on hold.

Furthermore, the recent increase in VAT has significantly increased inflation and even though this should not be relevant for the long-term monetary policy perspectives it nonetheless complicates further for the BNR.

So, while the deep economic crisis in Romania warrants easing of monetary policy it seems that the option is not available to the BNR in the present challenging environment. In conclusion, we believe BNR governor Isarescu will have a lot more to think about ahead of next week’s rate decision than his Czech colleague, CNB governor Singer. But they will nonetheless both end up leaving rates unchanged and that will be no surprise to the markets.

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