Will the BoE and ECB Under or Overdeliver?

In less than 24 hours, we have interest rate decisions from 3 countries:

1. New Zealand
2. United Kingdom
3. Eurozone

With the global easing cycle in full swing, rate cuts are expected all around. New Zealand and the UK have been two of the most aggressive countries when it comes to cutting interest rates.  At their last meetings, the RBNZ delivered a 100bp rate cut while the UK delivered a 150bp cut.  In contrast, the ECB has been the least aggressive next to the BoJ who don’t have much room to cut to begin with. The RBNZ and BoE’s commitment to lowering interest rates is one of the main reasons why the Euro sold off against the New Zealand dollar and British pound today.  The BoE’s heavier hand has driven EUR/GBP back towards its record highs.

UK Service, manufacturing and construction PMI reports are all at record lows, reflecting the deep slowdown in the UK economy. There is a risk of a 125bp rate cut if the Bank of England continues to be proactive.  Since their next interest rate cut will certainly not be their last, they may decide to do more now than later.

Although weak economic data may have the European Central Bank considering a 75bp instead of 50bp rate cut, they have a track record of underdelivering when it comes to monetary easing.  A 75bp rate cut would be largest in the ECB’s history.

Here’s a look at what is expected for the upcoming meetings.

Reserve Bank of New Zealand – 150bp Cut Expected on 12/03

The Reserve Bank of New Zealand cut interest rates rates by a full percentage point in October, citing “ongoing financial market turmoil and a deteriorating outlook for global growth. In a statement published in an article released by the RBNZ, the bank notes that “global developments have proven extremely disruptive and it will likely be some time before financial market conditions normalize. The Bank will continue to adopt measures as needed to maintain the stability of our financial system as far as possible in these difficult times.”Once again we see some very dovish statements made explicitly from central banks. The recession embattled country has plenty of ammunition as rates are at the very high level of 6.50%. While zero percent interest rates may not be a possibility, it is possible that we will be surprised by some extremely aggressive cuts. The market currently expects the RBNZ to cut as much as 1.5 percentage points in December and eventually take interest rates down to 5 percent. It is also important to note that rates have not fallen below 4.50% in the last ten years.

Bank of England – 100bp Cut Expected on 12/04

The Bank of England has been the most aggressive and proactive of the G-10 central banks in their attempts to ease monetary policy. The most recent cut of 150bp was a huge surprise to all traders and represents the largest single meeting cut to occur for any of the major central banks during the financial crisis. However what was even more shocking was the fact that the minutes from the most recent monetary policy meeting in early November suggested that they considered an even larger interest rate cut. Going into the December monetary policy decision, the market expects the BoE to ease by another 100bp. With the economy in a recession according to UK officials, interest rates could fall as low as 1% if the crisis continues well into the New Year. The BoE’s ability to cut by such a sizable amount was also reflected in the fact that inflation, once the primary concern, has eased considerably in the last few months. In addition to monetary stimulus, the UK government has been at the forefront of bank bailouts and fiscal stimulus.

European Central Bank – 50bp Cut Expected on 12/04
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British Pound: Headed for 1.45?

With the recession in the UK economy in full swing and the Bank of England scheduled to cut interest rates this week, further weakness in the British pound was expected. However not many people could have anticipated the degree of the sell-off that we saw in the British pound today.

The currency fell 3 percent or close to 500 pips against the US dollar, 2.8 percent (230 pips) against the Euro and a whopping 5.4 percent (800 pips) against the Japanese Yen. This price action indicates that the latest pieces of UK economic data suggest that the economy may be in weaker state than everyone initially anticipated.

The Bank of England has a tough decision ahead of them and a full percentage point rate cut is the minimum that we expect on Thursday.

The contraction in the UK manufacturing sector continues with the purchasing managers’ index falling to a record low of 34.4 in the month of November. Not only was the index much weaker than expected, but the new orders component also slipped to a record low. The deterioration in business confidence amid the mild improvements in consumer confidence suggests that consumers may not be translating their less pessimistic attitude into stronger spending. Mortgage approvals also fell to the lowest level in 9 years as the credit markets remain tight.

Bank of England Governor King has previously said that the single most challenging task at hand is to get credit to flow into the economy again. This is one of the main reasons why the central bank has been very aggressive in recent weeks. If the BoE still believes that over-delivering is the right solution, then we could see a bigger move on Thursday. Even if rates are only cut by 100bp, the next rate cut will certainly not be their last. While the Monetary Policy Meeting of December 4th will likely see rates decline to 2.00 percent, interest rates may not hit a bottom until 1.00 percent.

Talk of UK Adopting the Euro is Ridiculous

There was also talk of the UK adopting the Euro today which I think is ridiculous. The European Commission made a poorly timed statement reintroducing the notion that the UK should submit to joining the Euro-zone. The UK has denied any intentions to do so and the EC’s reasoning seems inconclusive in the fact that a unified Europe would promote efficiencies that would single-handedly thwart off a recession. When considering the ECB is largely recognized as being behind-the-curve in the rate cut arena, such an arrangement would result in unforeseen challenges for the UK. The BoE has not sat idly by waiting for destructive forces to consume them; in fact they have been one of the most aggressive proponents in the fight for reducing target interest rates. The central bank seems fully capable to sustain itself entirely on internal resources. A joint EZ – UK alliance would probably create more problems than solutions for the UK economy.

Technically, the GBP/USD is attempting to enter the sell zone, which I determine using Bollinger Bands. If the currency pair manages to break 1.4800, we could see a move down to the 6 year low of 1.4558.

Source: eSignal

Source: eSignal

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The Race to Zero Interest Rates

With the global economic downturn in full swing, one of the burning questions on everyone’s minds is who will be the first central bank to take interest rates to zero and how close will everyone else get?

We are in a global easing cycle and the varying aggressiveness of central banks around the world means that any country could be the first to see zero interest rates.

We expect December to be another active month for the foreign exchange market as central banks around the world take their interest rates to historically significant levels. There are 4 central banks with monetary policy decisions in the first week of December and all 4 are expected to cut interest rates. The closest to zero is the Bank of Japan, but having been there before, they are reluctant to revisit those levels. The US Federal Reserve and the Swiss National Bank have the second lowest interest rates. Both central banks are expected to continue to ease, but the Fed has been far more open about going to zero interest rates than the SNB. Realistically, Japan and the US will probably be the only ones to take rates all the way down to zero. Switzerland should be left with the second lowest interest rate when the dust settles followed by the Bank of England.

What Happens After Zero?
When a central bank runs out of room to cut interest rates, they resort to Quantitative Easing. This term was coined by the Bank of Japan in 2001 when interest rates were already at zero and the central bank stopped targeting the overnight call rate and turned to targeting a current account level. Their goal was to flood the Japanese financial system with liquidity by buying trillions of yen of financial securities including asset-backed instruments and equities.

It can be argued that the US has already engaged in Quantitative Easing as the government has recently announce plans to spend $800 billion to unfreeze the consumer and mortgage market. They have agreed to buy mortgage backed securities backed by government sponsored entities and could accelerate that if interest rates hit zero. Excess reserves have also increased significantly, driving the effective fed funds rate well below 0.5 percent. This would have been one of desired outcomes of quantitative easing. Last week, Fed vice chairman Donald Kohn said quantitative easing measures were under review at the central bank as normal contingency planning. The goal would be to encourage banks to lend more aggressively by coming in as a buyer at specified rates. Even though quantitative easing drove Japan into deflation, it was the key to turning around the economy and this is a risk that the US central bank may have to take.

Here’s where the major central banks stand and what is expected for the next meeting:

Federal Reserve – 50bp Cut Expected on 12/16

On October 29, the Federal Reserve took interest rates to 1 percent, which is near the record low reached in 2003 and 2004. While other countries have just started reacting aggressively to financial conditions, the Fed has been mounting cuts as far back as the middle of 2007. There has been no looking back since, as rates have been cut 425bp since 2007 and 250bp year to date. With interest rates near ultra low levels, the Federal Reserve has already resorted to unorthodox policy tools. More easing is expected with the markets torn between a 50 or 75bp rate cut in December. The FOMC statement will be particularly important this time around because the Fed will have the difficult decision of signaling a move to zero interest rates. In order to deal with this decision, they have expanded their monetary policy meeting from 1 to 2 days. Fed Chairman Ben Bernanke has remained dovish throughout the past few months which mean that another rate cut is practically guaranteed.

European Central Bank – 50bp Cut Expected on 12/04
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Bank of England Won’t Stand in the Way of the British Pound

The British pound is on a tear even though the minutes from the most recent monetary policy meeting indicates that the BoE toyed with the idea of cutting interest rates by more than 150bp.

The markets are ecstatic about the Bank of England’s proactiveness even if it means that UK interest rates will probably drop below 2 percent. Given the tone of the BoE minutes, we expect another 100bp rate cut at the next central bank meeting. The BoE is on a roll right now and the market expects big moves. Anything short of another 100bp rate cut could be a big disappointment. At the moment, the BoE is the most aggressive G7 central bank and expect the pound to join the ranks of the low yielders. However once the excitement dies down, we expect the pound to resume its weakness against the US dollar and Euro as the country closes its interest rate differential with the US dollar and the Euro.

King Can you believe that the Bank of England considered cutting interest rates by more than 150bp at their last meeting. According to the minutes, they only limited the rate cut to 150bp and not 200 or 250bp because they were afraid of shocking the markets. As I recall, 150bp at that time was quite a surprise at the time! The decision was unanimous with all 9 members of the monetary policy committee backing the 150bp rate cut that took interest rates down to 3 percent.

Here are the specific reasons that the BoE gave for not easing more (in order of appearance in the minutes)

1. Uncertainty regarding fiscal policy
2. Desire to assess how measures to stabilize the financial system are working
3. Unwillingness to shock markets
4. Desire to retain some ammunition to support confidence in coming points

Point #1 suggests that we could see further fiscal stimulus by the Chancellor later this month. The UK government has gone above and beyond all of their G7 peers in trying to stimulate their economy, which should help speed up the recovery in the UK economy.

The MPC minutes also indicated that the BoE will not stand in the way of the British pound. The central bank wants to gradually ease interest rates (if 150bp can be seen as gradual) to limit the sell-off in the pound, so that it does not cause a sharp run up in inflation. Clearly, the BoE has no qualms about the 25 percent depreciation in value of the British pound against the US dollar and they are quite comfortable with further weakness in the currency as long as it is gradual.
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Global Unwind Continues, Paulson Doesn’t Help

The global unwind continues this morning with US equities, commodities and currencies taking another beating. The US dollar and Japanese Yen continue to outperform with the British pound hitting a fresh 5 year low.

The story is still the same, which is sell first and ask questions later. It is earnings season and the reports that we have seen so far are a harsh reminder of the growing problems in the US economy. Retail sales are due for release on Friday and the warnings from retailers indicates that consumer spending has slowed materially.

Best Buy cut its full year forecast today, DHL is shutting down its US operations and Circuit City became the 14th retail chain to go bankrupt, joining companies like Linen N Things and Steve and Barry.

We are in a global easing cycle and the market expects central banks around the world to follow the UK’s aggressive interest rate cuts.

Central Bank Meetings: What Do I Expect for December

Federal Reserve: 50bp cut
Bank of England: 75bp cut
European Central Bank: 50bp cut
Reserve Bank of Australia: 75bp cut
Reserve Bank of New Zealand: 75 to 100bp cut
Bank of Canada: 50bp cut
Bank of Japan Japan: no rate cut

Paulson’s comments aren’t helping either:
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