Next week sees the last 2015 meeting of the US Federal Reserve and it follows a year where it has hinted at an interest-rate rise several times but not done it. Over recent days and weeks it has been ramping up the rhetoric and what we now call Open Mouth Operations to a new peak. If it was a game of chess then one would be wondering if they have totally endgamed themselves. However central bankers can be slippery people as Talking Heads put it. After all last week saw Mario Draghi disappoint expectations he had deliberately raise in his speeches and then raise them again only a day later!
the decision to re-invest the principal payments on maturing securities for as long as necessary will add EUR 680 billion – some 6.5% of the euro area GDP – in liquidity to the system by 2019,
Oh and we got kind of a default view of what the beginning of a monetary policy tightening by the US Federal Reserve might do to the US economy.
our measures will add almost 1% to GDP between 2015 and 2017.
If monetary stimulus raises GDP then maintaining QE as the US Federal Reserve did last year and then nudging interest-rates higher is likely to apply something of a brake, according to Mario anyway.
The fallacy of a 0.1% move in interest-rates
We saw one of these last week which reflected more the ECB’s intention to be seen to do something rather than being something which will have much if any influence on the real economy.
First, as regards the key ECB interest rates, we decided to lower the interest rate on the deposit facility by 10 basis points to -0.30%.
Yes there will be an impact on banks who at the time of writing have 698 billion Euros exposed to that rate but as to the real economy which has already seen between 4% and 5% of interest-rate cuts? Not much and maybe nothing. Ironically if there is something it may be contractionary if the banks trying to recoup their losses by raising margins.
In the arcane world in which central bankers live we cannot rule out a 0.1% rise in interest-rates next week even though it would give few if any benefits to the real economy and raise risks in the financial one.
The world has already changed
What I mean by this is that financial markets have already made much of the adjustment to a post interest-rate rise era. The clearest example has been the rise of the US Dollar over the past year or so in response firstly to the slowing of the monetary expansion and finally promises of a tightening of policy. The US Federal Reserve follows what is called the broad trade weighted which has risen in round numbers from 102 in July 2014 to more like 122 as of the last update. It is a bit behind recent moves such a last week’s Euro rally but there has been quite a tightening of US monetary policy here via the exchange-rate and has probably contributed to the numbers suggesting a weakening in manufacturing.
Next we have the issue of longer-term interest-rates or bond yields. If we look at the ten-year or Treasury Note yield we see something intriguing. Whilst the impression is of yield rises in fact it was 3% as 2014 began and is 2.25% now. So over time we have seen a winding back of expectations of future interest-rate increases. Central bankers will claim this as a victory for the Open Mouth Operations of Forward Guidance whilst we note that in fact there has been quite a change in real yield expectations via the effect of falling oil and commodity prices. You see in January 2014 the bond manager Pimco was forecasting this for inflation.
this puts our headline CPI forecast around 2.0% YoY this year.
So a real yield on that rough and ready measure of 1% whereas with zero inflation it has been more like 2.25% this year so there has been a tightening already. Now all measures of real yields have problems as unless commodity prices fall again in 2016 inflation will pick-up but we have already seen a tightening.
This is much clearer at the short end which is why media reports have suddenly taken an interest in the 2 year yield which has recently got near to 1% compared to the recent nadir of 1% in mid-January. The catch here is what economic impact it has as for example fixed-rate mortgages in the US tend to follow either the 15 year or the 30 year yield. Here we have seen a tightening as the 2.22% for the 30 year has been replaced by a nice round 3% as I type this.
So if we add up both factors we see that there has already been quite a reaction to the interest-rate rise or indeed rises hinted at. Thus it is possible that an interest-rate rise might see a US Dollar fall if subsequent events suggest that the increase might be rather lonely.
The impact abroad
Regular readers will be aware of the concept of a “carry trade” and the dangers that it brings. The bursting of the carry trade in the Swiss Franc and Japanese Yen post credit crunch highlighted this. Well take a look at this from the Bank for International Settlements and the emphasis is mine.
Since 2008, dollar credit has grown more rapidly outside the United States than inside…….. Dollar credit also expanded owing to its substitution for local currency credit given favourable dollar interest rates and exchange rate expectations.
A bit awkward on two counts here as the exchange-rate expectations bit has seen a US Dollar rally and maybe now interest-rates will rise. So on what scale might this be an issue?
Dollar credit to non-banks outside the United States reached $9.8 trillion at end-Q2 2015. Borrowers resident in EMEs accounted for $3.3 trillion of this amount, or over a third. EME nationals resident outside their home countries (for instance, financing subsidiaries incorporated in offshore centres) owed a further $558 billion.
So quite a lot and even the BIS notes the dangers if you think through the implications of this part of its conclusion.
Until recently, currency trends and interest rate differentials vis-à-vis the US dollar rewarded EME firms for substituting dollar borrowing for domestic currency borrowing. (EME means Emerging Market Economy)
Ah yes until recently and the danger is of course if financial markets decided to keep playing this by Aloe Blacc.
I need a dollar dollar, a dollar is what I need
Well I need a dollar dollar, a dollar is what I need
And I said I need dollar dollar, a dollar is what I need
And if I share with you my story would you share your dollar with me.
That would end the “uneasy calm” in financial markets mentioned by the BIS!
We see that the proposed/hinted US interest-rate rise has already had an impact as 2015 has seen a rise in the US Dollar affecting exporters and import substitutors and a rise in long bond yields affecting fixed-rate mortgages. I have argued in the past that the Federal reserve has tried to get away with just doing this and cannot rule out the possibility that it will do the same next week. But the risk for it doing that is that the markets then treat it like the girl who cried wolf.
If we look at a single interest-rate rise of 0.25% then there will be an impact on the financial economy but what impact on the real economy. In itself I would argue somewhere between very little and not much as after all we saw large interest-rate cuts which had disappointing effects or the US would not have entered the QE era and had a central bank with a balance sheet of around US $4 trillion.
The catch is that via changes to foreign exchange and interest-rate expectations that the opposite of something wonderful happens and we see a blow-out. So a “Black Swan” event or the like. Some of that is already in play and the danger is real now but we do not know if it will pass and unless it happens are unlikely to know how close we came. After all the Nostromo could have passed by the planet where the Alien was….
The US Federal Reserve mostly ignores foreign influences but I suspect that even it is bothered this time around which it keeps telling us that the interest-rate rises will be small as we wonder if in these times even small will prove to be too much. It would of course be quite an indictment of the last seven years should it prove to be so.