Forward guidance may fail to ease market rates given Fed taper fears

Carney and Draghi may struggle to diminish the market impact of Fed hawkishness, writes Liam Ward-Proud

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AGAP seems to be emerging between the trajectories of central bank policy on either side of the Atlantic. The Bank of England and European Central Bank (ECB) look to be moving in a dovish direction, with the release of (apparently uncoordinated) comments last Wednesday widely interpreted as an initial step towards “forward guidance” – and as a promise that interest rates will remain low for the forseeable future.

The Fed, meanwhile, is expected to begin tapering its QE programme later this year. The case for scaling back was strengthened by news that the US economy added 195,000 jobs in June. Fed chairman Ben Bernanke is due to speak tomorrow, and investors will scrutinise his statement for any further taper signals.

The FTSE 100 leapt 3 per cent to more than 6,425 after the Bank of England’s statement, a gain it built on by reaching 6,450 yesterday. Sterling, meanwhile, fell against almost all its major trading partners, with sterling-dollar below the $1.50 mark ever since. The market certainly reacted strongly to early signs of forward guidance. But as the Bank and the ECB branch out with their policy tools, it is unclear whether forward guidance will have enough firepower to affect market conditions as much as its proponents might hope.

TRANSATLANTIC CLASH
Despite signs that the UK’s economic outlook might be looking up, IG market analyst Chris Beauchamp identifies the US recovery as the main source of this transatlantic policy difference: “While the US is powering ahead, and the Fed is considering when to wind down its stimulus, the UK and the Eurozone are lagging behind, with further trouble in the Eurozone not unlikely”.

But despite difficult fundamentals, a recent note by JP Morgan global market strategist Dan Morris points out that, before Wednesday, markets had still been pricing in an interest rate rise of between 0.5 and 0.7 per cent in Europe and the UK by the end of 2015. But the Monetary Policy Committee’s (MPC) suggestion that expectations of rate hikes in 2015 were “unwarranted”, along with Mario Draghi ruling out any rises “for an extended period of time”, seemed to have lowered these expectations. Interest rates in futures markets for 2015 fell 0.11 per cent for the Bank and 0.13 per cent for the ECB following the comments.

These gains, however, were reversed by US non-farm payroll data last week, which raised the prospect of US monetary tightening. As of last Friday, market expectations were that rate rises would come both sooner and more steeply (see chart).

This reversal highlights the dangers faced by Carney and Draghi. Any attempt to reassure markets that there will be no credit tightening in the near future could be sent off course by expectations that the Fed will move in the opposite direction. As William Hobbs of Barclays said in a recent note, “no matter what regional central bankers may say, government bonds around the world are preparing for US monetary normalisation.”


POLICY RATES AND REALITY
Even without the danger of clashing policy, it is not certain that the promise of low policy rates will necessarily translate into lower market rates. Research by JP Morgan into real US rates show that the interest on 10-year Treasury bills ranged from 1.4 per cent up to 4 per cent, even when the Federal Funds rate was flat at 0.25 per cent between December 2009 and January 2013. Over the same period, investment grade corporate credit rates varied by over 2 per cent. As Morris points out, “many other factors determine the costs of funds that companies and individuals borrow.” Forward guidance, he says, may ultimately be a sign that traditional monetary policy has reached its limits.

Even in Carney’s native Canada, where he employed the policy in spring 2009, the evidence as to its effectiveness is mixed. A recent ING note references a research paper by the Bank of Canada’s Zhongfang He, which concluded that the effectiveness of forward guidance was “not statistically strong and subject to caveats”. Despite the promise of stable policy rates, investors could see further volatility in the fixed income market.

CURRENCY IMPLICATIONS
In any case, ING foreign exchange strategists see “huge uncertainties as to whether Carney will link monetary policies to economic targets”. This uncertainty, arising in part from a lack of clarity around what forward guidance might entail, could push sterling-dollar as low as $1.40 later this year. Tradenext head of strategy Ronnie Chopra sees similar falls as likely, but points out that a decline is “very much an aim of governor Carney, as he seeks to boost exports through a weaker currency.” The question is whether sterling’s fall will be a managed one, or altogether more dramatic.

Against the euro, however, sterling should stay relatively stable. Barclays currency strategists Petr Krpata and Rachel Russell expect euro-sterling to trade “broadly flat at £0.87 as the central bank’s dovish stances should largely offset each other.”

But it is clear that the challenges facing the Bank and the ECB are of a sharply different kind to those facing the Fed. If Bernanke pushes ahead with the unwinding of quantitative easing sooner, however, the problems facing Carney and Draghi may become even harder to solve.