It is only the Fed

The slogan “it is the economy, stupid” is attributed to Bill Clinton’s first presidential election campaign. For many market participants, today’s version had to be “it is only the Fed, stupid”.

There is much discussion, especially in Germany about the independence of the ECB. However, this discussion centers on independence from fiscal policies of the eurozone member countries. But even the head of the German Bundesbank, Mr. Weidman, the strongest opponent of OMT on the fear the ECB would lose it independence, never regarded the ECB monetary policy as being dictated by the FOMC. However, this had been a widespread believe in financial markets.

The best example for this unjustified believe were the comments from some traders quoted by ThomsonReuters after the release of the final figures of the PMI for the eurozone and some member countries. As the PMI was slightly stronger than expected, bonds and stocks had been sold on expectations that the ECB would end it expansionary monetary policy soon (see also comment from Monday, July 1, 2013).  But the eurozone is still in a recession and GDP growth forecasts for the strongest economy, Germany, had been revised lower lately by some institutions to a mere +0.3% in this year.

Unlike the Fed, the ECB has only a single mandate of maintaining price stability. The ECB’s inflation target is to keep harmonized CPI inflation close to but below 2% in the medium-term. This allows even for some temporary overshooting of the target as long as the medium term inflation outlook remains well anchored. But in a recessionary economic environment, there is little underlying inflation risk. Thus, it is not rational expecting the ECB to end the expansionary monetary policy only because some PMI figures approach the 50 threshold.

Despite earlier comments from ECB president Draghi, financial markets remained in irrational mode. This induced the ECB council to send another clear message to financial markets. Breaking with the tradition of stating that the ECB council is not pre-committed, the ECB council stated that the key interest rates will stay at the current or lower level for an extended period of time. But unlike the Fed, the ECB gave no clear guidance how long this extended period will last. Questions during the press conference about the duration were only answered by Mr. Draghi as “not 6 month, not 12 months, but by an extended period”.

Similarly, it was also not rational to expect the BoE to end expansionary monetary policy anytime soon. The MPC did not embark on another round of bond purchases, but also did not send any indication there might be a shift towards a restrictive policy. Thus, whether the statement made by the BoE governor Carney was driven primarily by the change at the helm of the institution or by the irrationality of financial markets is of minor importance.  What counts is the message itself that monetary policy remains accommodative.

In the US, the labor market report has been seen as another indication that tapering the bond buying program by the Fed would be imminent. Two major banks, Goldman-Sachs and JP Morgan, now have revised their forecast and also expect the FOMC to announce at the September meeting to reduce the volume of monthly bond purchases. From our point of view, the labor market report was a good one, but not one pointing to any urge for the FOMC to scale down QE3.

The FOMC statements always refer to the unemployment rate as the second target and not to the non-farm payroll figure. Of course, a high number of newly created jobs month after month are one important factor for reducing the unemployment rate. But another important factor is the development of the civilian workforce. In the second quarter, the workforce increased by more than 800K to 155,835 thousand persons. In the quarters before, the workforce declined as many persons unable to find a job left the workforce. With the improved economic outlook, some of those leavers return again. This was the reason that the unemployment rate remained unchanged at 7.6% despite more new jobs than predicted had been created. It has to be expected that the increase of the workforce is going to continue. This return to the workforce is dampening the decline of the unemployment rate. But if the unemployment rate remains at the current level, it gets less likely that the FOMC will vote for reducing the volume of QE3. Whether job creation will be sufficiently strong to reduce the unemployment rate over the summer months has to be seen. But that the Fed enters tapering in September is not yet a done deal.

Thus, the outlook for monetary policy is divergence in the direction. In Japan, the target is to reach a CPI inflation of 2% within 2 years, which requires the BoJ to increase its balance sheet. The ECB and the BoE will remain expansionary of still some time. Only the Fed has currently an exit plan, but his plan is data dependent, but will not lead to an increase of interest rate target. Therefore, there should be little movement in short-term interest rates. It should then be the long-term government bond yields, which drive the movement of foreign exchange rates.

After the release of the US labor market report, the yield on the 10yr US T-notes jumped from 2.52% before the Independence Day to 2.74%. The spread over 10yr German Bunds widened from 85 to 104 basis points. Weakness in the US Treasury market is also pulling the yields on other safe haven government bonds higher, but not at the same magnitude. Thus, the spreads are widening and lead to a firmer US dollar.

At the current level, 10yr US Treasury notes start to get attractive for carry-trades. However, for financial institutions to enter such trades, also the upside risk has to be limited. This is at present not the case, as the uncertainty in the US Treasury market is likely to stay until the FOMC has made a clear decision and does not only lay out the road map. Thus, we still expect that yields on 10yr US Treasury notes could rise towards 3% before stronger entering of carry trades sets in. This implies that the US dollar could strengthen further against other major currencies.

Last week, we pointed out that the negative link between precious metals prices and the US dollar index remain well intact, but that the regression coefficients between precious metals and the S&P index as well as the US Treasury yield had reversed and became negative. Thus, a further rise of US Treasury yields is likely to exercise two negative impacts on the performance of precious metals, one directly and indirectly via the foreign exchange markets and a rising US Dollar index. Thus, also the third quarter, which just started, appears to be a negative on for the precious metals.