The reluctant euro

Bad news is good news?

A trader’s disbelief

Once again what didn’t happen this week was more interesting than what did. Non Farm Payrolls was far weaker than expected, dipping into negative territory for the first time in four years. But despite this disappointment the dollar did not collapse. Against the euro it ended Friday in the middle of the weekly range and a figure higher than where it was before the Non Farm numbers were issued. At 8:15 am on Friday morning the euro was trading at 1.4890, at the release it rocketed to 1.4953. It then spent the rest of the session drifting down to close just below 1.4800.

What are we to make of this? The bad news absorbed by the usd over the past two weeks is considerable, a 75 basis point emergency cut in the Fed Funds rate, a further 50 basis point reduction at the scheduled FOMC meeting and expectations of another 50 point in March. Negative job creation, a barely 50 manufacturing ISM, weak retail sales, a swooning housing market and a hammered stock market. One might ask what else does the market need to see before it takes the euro higher? Or to ask the question another way, is there any statistic that will convince traders that, for one-- the Europeans will not shortly have a slowing economy of their own to contend with and two—the ECB will not soon begin lowering EMU rates. Yes, spokesman for the ECB have been adamant and on message -- inflation is our concern, inflation is the target, price stability is paramount, we will fulfill our mandate. But to judge from the trading levels of the euro there is deep skepticism in the currency markets for that program. Perhaps another factor is the still unresolved accounting of many European banks relating to the American sub prime credit problem. How many more losses are waiting to be unveiled? Certainly the massive Societe Generale trading loss did not help market psychology. Currency traders are not happy buying the euro. Will they soon begin to sell? When the market wants to go in a certain direction sooner or later it finds the necessary rationale and the appropriate trigger.

Central Banks

European Central Bank

There is no market expectation for a change in the ECB rate policy or its unofficial tightening bias at Thursday’s meeting. The refinance rate will remain at 4.00%, the tightening bias will emerge intact.

ECB council members have kept to the bank official position without variance. The latest was Nicholas Garganas Governor of the Bank of Greece who said in an interview with Bloomberg News, that he was very concerned about the high inflation risk, noting that core inflation was at 2.3% in December and a year earlier it had been 1.6%. Our monetary policy is not led [by] what the markets expect. Our monetary policy depends on the assessment we make on the economic situation.

The market expectation for an eventual ECB rate decrease is not just a wish. Traders and analysts are not simply talking their book knowing that lower rates are good for business or helpful to bank profits or for some other purely selfish remunerative reason. The market 'expectation’ for a lower ECB refinancing rate is an expression of its collective judgment on European monetary policy and on how the ECB will respond to a future economic situation that is deemed to be very likely. If the market’s judgment differs from that of the ECB and its public policy pronouncements, that does not negate its validity. The ECB has several reasons, not all of them economic, for retaining its public anti-inflation mandate. Remember that the US markets had priced in rate cuts long before they occurred and remember too the Fed statements in the weeks between the onset of the financial and sub prime crisis in August and its first rate cut in mid September. Or recall Chairman Bernanke’s very deliberate rhetoric for much of the subsequent time. It is only very recently that the Fed has publicly subordinated inflation to growth. Even so, the Fed has been accused of caving to market desires. The ECB has even more policy strictures because of its inflation mandate so it also has a grater need to preserve its independence and credibility.

Federal Reserve

The Fed Funds target rate has now been reduced by 2.25% since the August sub prime crisis blew up. At 3.0%, with core inflation over 2.0 % and headline inflation much higher real interest rates are just marginally positive. Monetary policy is clearly loose. In retrospect, it slipped out of neutral back in September, but the fact was disguised somewhat by the Fed’s anti inflation flourishes.

In the final analysis the Fed’s ‘expected’ 50 basis point cuts in both the Fed Funds and Discount rate on Wednesday seemed not quite so expected as both the Dow and the dollar sold off after the announcement. The Fed’s statement while it did drop the use of appreciable to describe downside risks to growth and added that earlier actions should help to promote growth over time…, is not a neutral pronouncement. The rate reduction bias is in place. No other interpretation is possible after the recent events and no Fed rhetoric in the coming weeks will alter that perception. The next FOMC meeting is March 18th and expectations will remain high for further rate cuts, no other future would be rational at this point.

Bank of England

There is little doubt that the Monetary Policy Committee (MPC) will cut rates by 0.25% on Thursday, and equally little doubt that they will mention their serious ongoing inflation concerns.

Mervyn King was reappointed to another five year term as Governor of the Bank of England (BOE) and Chairman of the Monetary Policy Committee. He is know as an inflation hawk and has repeatedly voiced the opinion that rate cuts are not a foregone conclusion. David Blanchflower, the most outspoken dove on the MPC said that the bank should cut rates to get ahead of the curve. It appears Mr. Blanchflower will get his way.