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What’s Next from the Central Banks?

Posted on: 13 September 2017 , by: Darren Sinden , category: Market Review

What’s Next from the Central Banks?

What the next moves by central banks could mean for markets and the Dollar

When the ECB Council met on September the 7th it decided to leave interest rates and QE (quantitative easing) unchanged. Mario Draghi, the ECB president, was guarded in his press conference comments, as he had been in Jackson Hole Wyoming. Draghi was mindful no doubt of the market reaction to the remarks he made in Portugal at the end of June. He did, however, admit that the value of the Euro was a source of concern and emphasised that Eurozone QE could be expanded or run for an extended duration, should that be required. 

Markets remain apprehensive, knowing that the Federal Reserve will meet on September 20th. The expectation is that the Fed will shed light on how it intends to reduce its $4 trillion plus balance sheet. Perhaps indicating a timescale, an end figure and an order of service.

The ECB finds itself some four years behind the Federal Reserve's trajectory. Eurozone QE is alive and well, and Eurozone base rates are in negative territory. The Fed, of course, announced it was to taper and ultimately end QE, in December 2013. The Fed brought its QE program to a conclusion, ten months later.

Markets now think it's possible that ECB is reaching a similar position. In that, it will shortly have to decide whether it can scale back its monthly asset purchases and ultimately end them altogether. Despite Mr Draghi's remarks to the contrary. 

The ECB has previously moved to reduce the volume of its asset purchases. Trimming them from €80 billion per month to €60 billion in December 2016. Though it also extended the tenure of the QE plan (by three months) to the end of 2017, at the same time. 

So what are the challenges facing two of the world's most influential central banks?

Markets do not believe that the ECB will raise interest rates anytime soon. 2019 is the most likely juncture. In fact, Mr Draghi made it clear in his recent press conference that negative interest rates in the Eurozone are likely to be around, well after QE has finished.

Tapering or reducing its monthly asset purchases below €60 billion per month may soon be a practical necessity for the European Central Bank rather than a policy goal; as it is running out of things to buy, in particular tightly held German government bonds. The ECB has seen the Euro appreciate by more than +14.0% year to date against the US Dollar. The trade weighted Euro Index has added +8.8% so far in 2017 contrasting sharply with the -10.50% fall that Dollar Index has endured in 2017. See below:

Euro IndexThat currency strength may be a vote of confidence by the markets in the European recovery. But it has also helped to damp down Eurozone inflation. That's because a stronger Euro reduces the price paid for imports from outside of the Eurozone. Broad based inflation is currently running at +1.50%. But the narrower core inflation read is at just +1.20% and therefore well below the central bank's +2.0% target.  

In effect, the stronger currency is importing disinflation into Europe. Falling energy prices in Euro terms have also helped to dent investor expectations about future inflation rates within the Eurozone. 

The ECB may find itself becoming an unwitting victim of its own success. And it will need to tread carefully into the year end. For fear of driving the single currency back towards $1.30. A level at which the Euro would start to hinder the very recovery that helped to push it higher in the first place.

Room for manoeuvre is limited

The Federal Reserve is in on a sticky wicket of its own. It would very much like to tighten US interest rates again in 2017 (and more than once) if it could. Yet the domestic political situation and uncertainty about the health of the US economy mean that it will probably be unable to move before 2018. Fed Funds futures currently suggest any move in US interest rates may not come before September next year. While US Treasury Bonds imply that US interest rates will only be marginally above their current levels, two years hence. Hardly a ringing endorsement for continued growth. And that's the point. The Fed may want to raise rates to give itself some headroom, to be able to cut again, at a later date if required. Yet the bond markets are telling us that rates are likely to stay lower for longer.

That is a worry because if the US economy were to go into reverse, then the Fed would have limited room for manoeuvre on the downside from current levels.

Of course, you could argue that by selling off bonds from its balance sheet the Fed could push bond prices down and yields and interest rates up. And indeed that could be a short term fix. 
But recent research by bankers HSBC shows that over the longer-term, US 1 year yields, or interest rates, have been lower than you might think. For instance, the 100-year average for one-year rates is just +1.35%. The 10-year average is a negative figure of -0.35%. See the chart below:

US 1 Year Interest Rates

Against that backdrop and long term downtrend then it's not hard to imagine the Dollar remaining under pressure to the year end and beyond. Especially given that rising interest rates or expectations thereof are one of the fundamental drivers of currency appreciation.


For more analysis, you can check out Darren's Daily Market Update (key market news in minutes).

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