FX Daily: BoE takes the lead as first leading central bank to hike

22nd May 2014

  • Mainstream UK parties are set for a political earthquake for a “political earthquake”, with UKIP expected to make strong advances in the euro vote, with some polls tipping them to take first place. The UK goes to the polls Thursday with both European Parliamentary elections and local council elections. (The FT)
  • Talks on the Trans-Pacific Partnership free trade agreement need a “critical push”, towards a final conclusion, according to Malaysian Prime Minister Najib Razak, who said he would ask Japan’s Abe to nudge the talks in the right direction. (Nikkei)
  • The PBoC’s Shanghai branch is expected to announce details of how to open “free trade accounts” in the newly-established Shanghai Free Trade Zone. Sources said the PBoC rules today will forbid fund transfers between offshore and onshore accounts to prevent inflows of speculative “hot money”. (Shanghai Securities News)
  • Sources close to China Development Bank said the policy bank has “probably” received funding from the PBoC via its revitalising relending facility. The funds will be used for the government’s public housing program. (21st Century Business Herald)
  • China’s National Association of Financial Markets Institutional Investors has again lowered the threshold for Chinese companies selling short-term commercial paper of less than 270 days by allowing companies with AA-ratings to sell. (Economic Information Daily)
  • China HSBC May Flash Manufacturing Index rebounded sharply to 49.7, up from 48.1 in May.
  • Japan Manuf. PMI rebounded to 49.9 in May, recovering off April’s low of 49.4 following the introduction of the sales tax hike.
  • New Zealand April Job Adds rose 2.6% MoM. Following a upgrading reading of 1.2% in March.

The agenda at the Federal Reserve has subtly shifted to returning policy to normal. In the April 29-30 meeting, FOMC members discussed how they would untangle themselves from an aggressive easing policy which has left them in completely uncharted waters. The Fed had enough trouble reducing the pace of its asset purchases after committing itself to unlimited quantitative easing, a policy never seen before. This wreaked enough havoc on markets. Now they must contemplate how they will increase the Fed Funds Rate before reducing their balance sheet of $4 trillion. The statement noted that because “the Federal Reserve has not previously tightened the stance of policy while holding a large balance sheet, most participants judged that the Committee should consider a range of options and be prepared to adjust the mix of policy tools” Effectively trial and error, with the choice of tools being fixed-rate overnight reverse repurchase operations, term reverse repurchase agreements, and the Term Deposit Facility. A number of participants even considered a form of forward guidance to control expectations of a run down of the Fed’s balance sheet. The Fed has led itself into a monetary policy mess that won’t be easy to escape from. We may well see further volatility, reminiscent of last years taper tantrum, as the Fed begins to get to grips with its bloated balance sheet, but only after rates rise.

As regards the immediate policy decision of when rate will rise, market participants focused on a single line. With inflation expected to remain well below the Committee’s 2 percent target and “the unemployment rate still above participants’ estimates of its longer-run normal level, the Committee did not, at present, face a tradeoff between its employment and inflation objective, and an expansion of aggregate demand would result in further progress relative to both objectives”. Effectively the Fed’s inflation pressure gauge is not flashing red, giving the Fed has more time to keep interest rates low to eat away at the economy’s spare capacity. The Fed kept its assessment of the broad economy unchanged hence yesterday’s much thinner policy minutes at only 10 pages, but continued to note long-term unemployed and involuntary part-time workers above historically averages. The housing market was one again given a downbeat review and listed as a downside risk to growth. The housing sector has taken the brunt of tapering but recent reports of policymakers easing mortgage conditions create an unnerving déjà vu to pre sub prime crisis.

The April Fed minutes had no bearing on expectations for the first US rate hike with yields largely unchanged. This contrasted with a recent slew of UK releases which have made UK rate hikes all the more imminent. The first was higher UK inflation with the core rate now back to the BoE’s target of 2.0%. Then April retail sales surged to 7.7% annual growth. This stellar sales growth wasn’t even see in the heady days of 2006-2007 which led us to brink of the 2008 crisis. The fact that consumer credit is rising and real wages effectively haven’t grown means instability is spreading throughout to the UK economy, moving from the housing market to consumer debt. The Bank of England reporting that for some members the interest rate decision was “more nearly balanced” was very timely. There was “considerable uncertainty” about the amount of spare capacity and inflation in the economy and an admission that if interest rates are to rise slowly going forward, they will have to rise sooner. The BoE is now front of the race of leading central banks to tighten policy and we could get our first vote for rates increases before September with an actual hike in Q1 2015. The Fed in contrast lags well behind and is unlikely to hike until mid 2015 at the earliest as the economy puts in a mediocre performance of 2% annual growth. The dollar will continue to trade sideways while sterling gains further grounds with the $1.70 level in sight. Sterling buyers should take advantage of near term dips now while if you are lucky enough to be selling sterling favourable rates above $1.70 such be achievable within a three month view.

Australian dollar took a leg higher this morning after Chinese manufacturing PMI suggested the economy is stabilising around the 7% level. The Aussie took a tumble Tuesday morning off the back of RBA policy minutes, which said what we should all know by now, rates are on hold. An article in a local newspaper also added momentum to AUD’s fall by suggesting the S&P was looking to downgrade the sovereign following the Treasury’s budget. We have to query the timing of a downgrade now but also Australia’s recent budget reinforces the triple A position of the sovereign, not jeopardises it. Moody’s came out to publicly endorse the budget after it was announced. AUD is a triple AAA rated carry and as such there is little that can keep the aussie down. Aussie buyers should look to hedge around the low $0.92’s.