November 30, 2005
THE EUROPEAN RATE DEBATE
The dollar has found a reprieve in the last three months, in part due to the stillness that has characterized the monetary policy of the European Central Bank. The ECB has kept the Continent's benchmark rate at 2% for the last 30 months while the Fed has incessantly raised the price of money since June 2004 to the current 4.0%, thereby creating a tidy premium in dollar assets over euro-based counterparts. Although that premium isn't about to evaporate any time soon, the ECB may start lifting rates, giving dollar bulls new reason to worry.
Indeed, with such a hefty incentive to own dollars and related assets, it's been easy to overlook the fact that the United States has a massive trade deficit with the rest of the world. Normally, such a mountain of red ink would foster selling the afflicted currency. But these aren't normal times, and so the dollar has enjoyed a potent rally in recent months.
Expecting more of the same may be up for review, although the notion that the ECB would raise interest rates tomorrow has been a staple of chatter in trading rooms the world over for some time now. Nonetheless, reaction to the anticipated event has been mixed, with some arguing that the ECB needs to nip inflation in the bud by moving rates up a bit.
A counter argument came yesterday when the OECD weighed in and advised the ECB to do no such thing and instead keep rates at 2%. Yes, global economic growth has been "especially vigorous," the OECD observed in its Economic Outlook No. 78, November 2005. But that doesn't necessarily warrant higher rates, the Paris-based institution reasoned. Global growth has pushed up energy prices, and that's added another weight on Europe, which is still struggling with relatively sluggish growth.
"The fledgling European expansion has been facilitated by low long-term interest rates, euro depreciation and buoyant export markets, although final domestic demand is still growing below trend," the OECD explained. Ergo, keeping euro rates low, in the face of rising U.S. rates, would help keep the euro weak and thereby boost European exports.
We'll know tomorrow if the ECB will buy into the OECD's policy prescription, but the pressure for a European rate hike is growing. Bloomberg News today reported that the ECB raised its 2006-2007 inflation outlook for 12-nation eurozone countries to an average of 2.1%, up slightly from a 1.9% made back on September 1. The eurozone economy, by contrast, is expected to grow by 1.9%, or below the inflation rate.
An outlook of growth that's below the inflation rate is all but expected to insure a rate hike tomorrow. "A more favorable growth outlook and upside risks to inflation are going to be the justifications for higher interest rates,'' Guillaume Menuet, senior economist at Moody's Investors Service in London, told Bloomberg News. "For the first time we have 2006 and 2007 inflation forecast above the ECB's limit.''
But wait--there's more. Today, European Union statistics office announced that eurozone inflation in November is projected to be an annualized 2.4%, down slightly from 2.5% in October. How will that impact the ECB's decision tomorrow? On the one hand, inflation seems to be slowing at the moment. But even a drop to an annual rate of 2.4% is nothing to take lightly in an economy that's growing well below that rate.
Warranted or not, the prospect of higher European rates after a 30-month lull has caught the attention of bond traders in the U.S. The 10-year Treasury yield yesterday surged by nearly 8 basis points to 4.48%, the highest closed since November 16. The dollar bulls are becoming cautious too, with the euro gaining against the buck in recent days.
Arguably, the pressure remains on the Fed to keep raising interest rates too, thereby locking in the current premium in dollar rates vs. euro rates. The government's latest estimate of third-quarter U.S. GDP released today shows a revised 4.3% annualized real rate of expansion, up sharply from the initial 3.8%. The economy, in sum, may be growing faster than previously recognized. But while U.S. economic growth has been revised upward, inflation (as per the implicit price deflator number in today's GDP report) hasn't followed, and in fact has been revised downward slightly to 3.0% from 3.1% in the previous government estimate for the third quarter.
Perhaps that explains why the market is warming up to the notion that the Fed rate hikes may soon come to an end sometime in the first half of 2006. The March 2006 Fed funds futures contract is currently priced for a rate of 4.5%, or 50 basis points above the actual rate at present. In fact, the March 2006 Fed funds contract has been more or less predicting 4.5% now for a month.
Yes, dollar-based assets still carry a sizable premium over their euro counterparts. But the prospect that the Fed may be nearing the end of its rate hikes, combined with an ECB that may be starting to hike, promises to be the new new thing in currency and bond trading rooms around the world. At the very least, the prospect of an ever-widening yield premium in the U.S. vs. Europe seems destined to end in the foreseeable future.
Posted by jp at November 30, 2005 9:46 AM
I am one of those USD bulls that has turned a new cautious leaf. I think there are significant uncertainties with respect to both ECB and Fed policy. Created a matrix on my blog that helps the analysis in relation to EUR/USD:
I'd say a 25bp hike tomorrow is a given, as Trichet's credibility is on the line. Nevertheless, the OECD's comments are a stark reminder that the ECB need to be very careful in taming the perceived inflationary beast, which is pretty tame already.
The big question is how much of a perceived narrowing of the rate differential will it take to knock the USD of its new found perch? I just wish I had the answer.
Posted by: ABOBtrader at November 30, 2005 7:46 PM