Tags: Fed | us | europe | eurozone

Fed, ECB Eventually Will Have to Change Thinking and Tactics

Friday, 04 May 2012 08:21 AM

Speaking Thursday at the University of California, Santa Barbara, Philadelphia Fed President Plosser said projections on GDP growth for this year and next range from 2.4 percent to 2.9 percent for 2012 and for 2013 the range was 2.7 to 3.1 percent, which suggests moderate growth this year, with some pick-up for 2013.

The projections for unemployment range from a low of 7.8 percent to a high of 8.0 percent by the end of 2012.

As for the end of 2013, expectations range from a low of 7.3 to a high of 7.7 percent. His strictly personal expectation on growth is for about 3 percent in both 2012 and 2013. Inflation projections are near 2 percent for 2012 and 2013.

No wonder that he, together with San Francisco Fed President John Williams and Atlanta Fed President Dennis Lockhart, coincide completely when saying they would not favor more monetary policy easing unless economic conditions took a turn for the worse.

By the way, Warren Buffet says the U.S. economy is better now than it was three to four months ago, but the economy is not growing at a fast rate.

Truth be told, as always, there remains a great deal of uncertainty and as physicist Niels Bohr once said: “Prediction is very difficult, especially if it is about the future…”

Also, European Central Bank President Mario Draghi, in comments after the ECB kept rates unchanged at 1 percent, said the eurozone economy was likely to recover this year, although the outlook remained vulnerable to downside risks.

He added that inflation was likely to remain above 2 percent this year. Interestingly, Mr. Draghi foresees now, notwithstanding all the recent and ongoing negative news, a gradual rebound in the eurozone in the second half of the year.

It must be said he demonstrated a decidedly hawkish posture at the monthly ECB press conference yesterday dismissing any speculation of an imminent rate cut or even an additional LTRO (long-term refinancing operation.)

He offered no hope whatsoever, for the time being at least, the ECB will provide more stimuli to help the struggling eurozone with its devastating sovereign debt crisis.

Yes, it looks like it’s the “EMU’s northern contingent” or the so-called “euro-mark countries” that includes Germany, the Netherlands, Austria, Luxembourg, Belgium, but also “probably” France and Finland and possibly Estonia and Slovakia that have the ECB’s ear right now and not its southern neighbors, which are Portugal, Italy, Ireland, Greece and Spain or what's called the “PIIGS countries.”

If that will remain so after the elections on Sunday in Greece and France is another question because the French will have to decide if they elect a “socialist” president or not, but also because the elections in Greece could turn out to be even more important than the elections in France as the Greeks will have to make the fundamental and extremely important choice of staying in the euro or not.

You shouldn’t be surprised in case the Greek election on Sunday doesn’t allow to set up a "functional" government we easily could see new and another Greek election within a month, which in turn could threaten the viability of Greece's latest bailout package. Keep in mind, in Greece there are now 10 parties polling above the 3 percent threshold for winning seats.

What’s for sure is that the Greeks are likely to elect the most fragmented Parliament since the restoration of democracy and fall of Greece's military junta in 1974.

Whatever comes out, high volatility in the near term as well as the fact that several eurozone sovereigns will have to face further downgrades by the rating agencies are a couple of the very few certainties for now. For long-term investors all that calls for extreme cautiousness. For traders this also translates in interesting times.

As an investor one could ask if there is really so much trouble in Europe, why isn’t the euro much weaker against the dollar where for the past three months the euro/dollar cross rate has traded in the range of 1.30-1.35 while at the same time since the middle of March European equities (Eurostoxx 50) are down more than 10 percent and 10-year yields on Italian and Spanish bonds have risen by more than 50 basis points (bp) with, as of yesterday, 71 bp for Italy and 85 bp for Spain?

Sorry, and this is somewhat complicated, but using one of the broad based financial fair value (FFV) models for the euro/dollar cross rate that take into account interest rate differentials, global (MSCI) equities, eurozone versus U.S. equities, and oil prices over a 12 month time span we see that the euro/dollar cross rate is broadly in line with its market drivers.

Interestingly, longer term yields have recently supported the euro against the dollar. The rise in longer-term interest rate differentials is largely due to the fall in U.S. yields that we have seen since the end of March.

Also, we shouldn't overlook the fact the Fed has eased monetary policy much more aggressively than the ECB since the 2008 crisis, while the Fed has remained sounding dovish, even though a gradual recovery in the U.S. is taking place.

The ECB on the contrary has kept a more hawkish rhetoric that was confirmed by ECB President Mr. Draghi despite all the stress that the eurozone is going through now.

Nevertheless I think these attitudes of the Fed and the ECB will change, with the Fed gradually allowing yields to rise and the ECB to become “sounding” more dovish or even easing policy a further notch. For investors it’s important to keep in mind that this will be a gradual process.

In my opinion there is small risk when taking investment decisions expecting a grinding lower in the euro/dollar cross rate, with over the next few weeks potentially with volatile range trading within 1.30-1.35, but further out, I think 1.20 is likely within more or less a 12 month time span. Of course, I don’t have a crystal ball and this is my personal opinion.

About the persistence of the euro’s strength we should also keep into account that significant deleveraging by European banks within the euro area during the second half of 2011 by far exceeded those of the other major currencies and, as such, has provided support to the euro on a relative basis.

On the contrary, until the eurozone sovereign debt crisis began in 2010, central banks had been progressively increasing their allocations toward the euro, which converted them in structural buyers of the euro, which has been one of the sources of support for the euro. Recently, global rebalancing has decreased significantly the overall size of current account surpluses, which are now about 30 percent smaller than at their peak in 2009. Besides, we have seen global central banks slowly but steadily shifting away from the euro and change the composition of their overall preferences.

No doubt the eurozone sovereign debt crisis has affected the attractiveness of the euro as a reserve currency and it is highly unlikely that central bank flows could return to the single currency in any meaningful way, unless and until the eurozone debt issues ease, the threat of future restructurings is eliminated and foreign investors return to European government bond markets. That doesn’t mean that sovereign wealth funds (SWFs) could have done and do the opposite, but that is extremely difficult to prove.

Bottom line, I expect euro/dollar cross rate from here on to fall gradually to even below $1.19, which was its most recent low in June 2010, within more or less the next 12 months. I also expect the Fed to continue toning down positive news on the growth front in order to avoid a sharp back up in yields.

At the same time, I also expect the ECB to be slow in easing policy in the face of market pressure and downside risks to growth in the eurozone. In my opinion, the risk premium on the euro should remain elevated, given ongoing concerns about fiscal solvency in Spain, extremely serious electoral risks in Greece and to a much lesser extend in France, and a very fragile eurozone economic outlook, notwithstanding that ECB President Mr. Draghi said he expects positive eurozone developments in the second quarter of 2012. Time will tell if he’s right.

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Friday, 04 May 2012 08:21 AM
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