Edging towards an exit strategy

As global equities rally to new highs for 2009, the USD falls to new lows for the year and the price of gold rises to near record high, there will be increased focus on which central bank will be the first to exit extraordinary monetary policy accommodation. Central bank implementation of extraordinary liquidity measures has helped to fuel the current rebound in risk appetite, optimism about the global recovery and contributed to an apparent end to the financial crisis. Fed chairman Bernanke's statement that the US recession is likely over is the latest catalyst fueling speculation that the financial crisis has passed and the US and global economy is set to recover. The global recovery will increase pressure on central banks to withdraw stimulus.

Fed

There appears to be a rift at the Fed over how quickly to hike rates and scale back quantitative ease as the US economy recovers. The FOMC will meet on September 22nd and the policy meeting is a key event risk for the financial markets and USD. A Washington think tank Medley Global Advisors says that at least two members of the FOMC board want to hike rates next week and a number of the members of the FOMC are discussing the potential timing for an exit from quantitative ease. Over the past few weeks there have been a string of better than expected US economic reports which suggest that the US recession has ended and the recovery may be stronger than expected. Fed officials will debate whether a continuation of accommodative policy will fuel inflation versus the risk that too soon a withdrawal of accommodation could derail the recovery. Premature hikes and withdrawal of liquidity in the 1930's in the US, and in Japan in 1990s, are blamed for choking off economic recoveries that emerged after the Great Depression and the 1990's recession in Japan. The 1990's Japanese recession was triggered by a build up of debt and the impact of cheap money that inflated property values. The 1990's Japanese recession was similar to the recent global financial crisis which was sparked by easy credit and the collapse in the housing market. Actions by the BOJ to prematurely withdraw liquidity and the government's failure to rid Japan of insolvent banks led to a lost decade for Japans economy. It is hard to predict when the Fed will begin to withdraw stimulus but we suspect that the Fed will err on the side of caution. The current straight-line rise in equities and the price of gold may make a number of Fed officials nervous about impact of continued central bank stimulus. Despite the fact that the price of gold is trading at 14 month high Fed officials seem to see limited inflation risk and US officials do not appear to be overly concerned about weaker USD as long as the decline is orderly. A more rapid fall in the USD and an uptick in inflation could quickly change Fed policy outlook and the FX landscape.

BOJ

The BOJ concluded two-day meeting Thursday and elected to hold rate policy unchanged at 0.1% and upgraded Japan's economic outlook. According to the BOJ, Japan's economic outlook is improving. Confidence at the BOJ is attributed to rising Japanese exports and improving global growth outlook. The BOJ has enacted unconventional extraordinary measures to boost credit liquidity buying corporate and commercial paper. At Thursday's meeting the BOJ appeared to be moving closer to an exit strategy from extraordinary liquidity measures. BOJ Governor Shirakawa said that the central banks intervention in the credit markets was designed to deal with severe crisis that has passed. Shirakawa's comments suggest that there is now less need for the BOJ to purchase bonds to boost liquidity. In July, the BOJ announced that it would extend its liquidity measures that were due to expire in September through December. Today's comments from Shirakawa suggest that the BOJ might be closer to allowing the liquidity measures to lapse after December, provided the Japanese and global economy continues to exhibit potential for sustainable economic recovery. The BOJ must also consider how the new Japanese government plans to increase spending to boost the domestic economy may impact Japan's economic outlook and the governments GDP debt ratio. It could be argued that the BOJ may become less generous with stimulus if the central bank board senses the new government will dramatically increase spending to boost growth.

RBA

The RBA is widely expected to be the first central bank to raise rates. The RBA did not adopt quantitative easing measures but at the start of the financial crisis last year the RBA cut interest rates aggressively. Australia's central bank cut interest rates by 425 bps between September 2008 and April 2008 and lowered the overnight interest rate to 49 year low at 3%. At the September RBA policy meeting the RBA left its cash rate unchanged at 3% and gave an upbeat assessment of the Australian economic outlook. According to the RBA minutes for the September policy meeting the RBA expects interest rates to rise when the economic recovery to sustainable. The minutes indicate that the RBA will need to counterbalance the risk of overstaying accommodative policy stance versus prematurely tightening. The RBA said that if growth continues to meet the RBA forecast the board will have to hike rates. Many analysts expect the RBA to hike rates before the end of the year. RBA rate hike decision will be dependent on upcoming data with reports on inflation and growth key. The RBA is not expected to tighten until the recovery is secure.

BOC, BOE and ECB

The BOC has pledged to maintain the current record low overnight interest rate of 0.25% until mid-2010, provided inflation remains in check. The BOC is generally upbeat about Canadian economic prospects and central bank has refrained from implementing quantitative ease. Therefore the BOC does not need to prepare an exit strategy from quantitative ease and unless inflation spikes above the BOC's  2% inflation target the BOC will be on hold until mid-2010. The BOC expressed concern about the strength of the CAD choking off recovery. BOC concern about CAD strength is an additional factor that will limit the BOC's decision to hike rates. BOC rate hike speculation could fuel further CAD gains. Strong CAD tightens credit.

BOE officials are divided over whether the BOE should expand quantitative ease. At the September policy meeting the BOE elected to hold rate policy steady at 0.5% and maintain the current level of bond purchases at £175 bln. The September BOE policy minutes indicate that the BOE board is split because of uncertainty about the UK economy as to whether or not there is a need to expand quantitative ease. The BOE is likely to be the last central bank to exit from quantitative ease. GBP should continue to underperform.

The ECB has tied exit from unconventional monetary measures to inflation risk. At the last ECB policy meeting the ECB elected to hold rate policy steady at 1% and indicated there was no rush to remove liquidity. The ECB has taken action to boost bank lending offering lenders cash (a record 629 bln in June) and expanding bank auctions to 12 months from 6. This contrasts with the FED and BOE's purchase of bonds to pump money directly into the economy. The ECB is expected to allow unconventional liquidity measures to expire naturally as long as prices remain stable.

Conclusion

The timing of Fed rate hikes and withdrawal of stimulus will be crucial to USD outlook and how far the USD may decline. Until the Fed signals the beginning of a tightening cycle the dollar may find limited support. Fed rate hike speculation may help limit USD downside but majority consensus is that a FOMC rate hike is a long way off. JPY will likely continue to benefit as the BOJ edges toward an exit strategy. JPY will also find support from the recent shift in intervention policy by the new Japanese government and by the fact that it is now cheaper to borrow in USD than JPY. The USD has become the preferred funding currency. The AUD is likely to continue to outperform and benefit from speculation the RBA will be the first central bank to raise interest rates. The key issue will be, once the RBA starts hiking rates will we see liquidation pressures of AUD. Investors will need to watch carefully how the Australian economy responds to higher rates. The ECB will likely remain on hold for some time with limited pressure to expand or withdraw unconventional monetary policy measures as the EU economy posts a slow recovery and inflation remains subdued. EUR price direction will remain closely correlated to risk sentiment. The BOC says interest rates will remain unchanged until mid 2010. CAD will continue to track commodity prices and recovery hopes. Growth linked currencies should outperform. The BOE will likely be the last central bank to pull the trigger which is negative for the GBP.