The Reserve Bank of Australia must be feeling pressure to provide financial markets with explicit forward guidance on the long-term direction of its interest rate strategy. These days, with central banks all over the world providing markets with forward guidance on rates in an effort to shape market expectations, the RBA is one of the few remaining major central banks to maintain a sense of anticipation at each meeting – rates could just as easily go up as they could go down. Even the European Central Bank has finally backed away from its sacred no “pre-commitment” policy. Check out my previous post on forward guidance here.
Increasingly these days, what was once considered to be “abnormal,” markets are beginning to construe as “normal.” A central bank that doesn’t provide forward guidance is increasingly seen as hawkish (“do they have something to hide?”) and markets tend to react by driving up its bond yields and their respective currency – effectively tightening financial conditions.
Oh yeah, I’ll tell you something
I think you’ll understand
When I say that something
I want to hold your hand
- “I Want to Hold Your Hand,” The Beatles
Hand-holding is getting to be very popular with the world’s major central banks. Effectively constrained by zero or near-zero interest rates, central banks have been putting greater emphasis on the effectiveness of their communications. Central bank “speak” – if used wisely – holds the power to ease monetary conditions as much as, if not more than, policy rate changes. Read more
Monetary accommodation was on the rise in May. Of the twelve major bank meetings during the month, nine resulted in cuts, two central banks held policy steady, and only one actually increased rates to control inflation.
While the Federal Reserve didn’t change direction, it sent mixed messages regarding its quantitative easing (QE) program. The minutes from the April-May FOMC indicated willingness to “increase or reduce” the pace of QE, a change from previous meetings that were primarily focused on QE reduction aspects. Read more
Growth is good. So, even at a revised 0.1%, German GDP growth could still be considered good. Sure, it wasn’t as much as economists had forecasted, but growth still beats recession – especially, after several months where the economic malaise in the Eurozone threatened to turn into a Teutonic Plague as well. The actual German output data has been much better than the dreary business surveys. Manufacturing orders (up more than twice what was forecast), industrial production (up 1.2% versus expectations of -0.1%), trade (surplus of€18.8 billion), and consumption all looked strong as the first quarter ended. Read more
One big concern for long-term investors is systematic risk, or risks that are endemic to an economy as a whole. Systematic risks, as opposed to company-specific risks, were behind the majority of the pain suffered during the global financial crisis. And I tend to think that in the United States, the systematic risks that came to a peak in 2007 were purged from the system pretty effectively by the intensity of that same financial crisis.
Europe, though, I fear still has a lot of systematic risks that are being masked by the massive liquidity injections from the European Central Bank. Like a bandage that’s covering a particularly nasty wound, programs like the LTRO (Long Term Refinancing Operations) are perhaps stopping the hemorrhaging, but they’re also obscuring complications that lie beneath.
A program like the LTRO has led to “round trip” financing of the debt of troubled governments by the European Central Bank through to those countries’ own local banks. I can’t but feel that this will all end somewhat badly for the Eurozone sometime in the next two to four years. Let’s say Spain defaults on its sovereign debt in the coming year or two. As it stands now, that default would hit local Spanish banks (big holders of Spanish sovereigns), and the ECB (another big holder of Spanish debt), and…and not many other people hold their bonds.
If you extrapolate that out to other troubled economies in southern Europe, I suspect that systematic risks would include the potential undermining of the Italian, Spanish, and Portuguese banking systems. It’s likely this bandage of liquidity that’s preventing this systematic risk from showing up in conventional volatility spreads.
Earlier this week, I participated in an economics panel at the Principal Global Investors Summit Series held in Des Moines, Iowa. There was a question posed that bears repeating. A client asked what the impetus would be for the ECB to engage in quantitative easing, or QE, as has been seen from the Federal Reserve and other central banks.
The key to answering this question is Germany and its central bank, the Bundesbank. Given Germany’s scarring experience with hyperinflation in the 1920s, the Bundesbank’s sole target was to keep inflation under control. Nicknamed “The Bank that Ruled Europe” because of its size and relative importance, the Bundesbank was the model on which the ECB was built. It essentially dictated the newly formed ECB’s monetary policy set-up, which is why the ECB has such strict inflation targets and now stands out as one of, if not the, most hawkish of the world’s central banks. The ECB’s inflation target, it’s unfortunate to say, I think is probably one of the reasons that Europe is in the trouble it is.