Central Banks Part 2: The ECB

Last meeting: December 2, 2010

Prior to last: November 4, 2010

Next meeting: January 13, 2011

Chairman: Jeane Claude Trichet

Currently, ECB's monetary stance is accommodative. Apart from leaving the main refinancing rate at 1%, the central bank delayed exit of non-standard measures and announced in December to keep providing unlimited liquidity to the market through Q1, 2011. The ECB extended the full allotment of the 3-month tender for a quarter. The 3-month LTRO (Long-term refinancing operation) will be conducted on January 26, February 23 and March 30 as fixed rate tender procedures with full allotment. In order to restore market confidence in the face of the sovereign crisis, ECB started buying government bonds in May under the Securities Market Program (SMP). As of December 24, the value of the accumulated purchases under the SMP was EUR 73.5bn with most of it spent during the first 3 weeks of the program. Although the ECB tried hard to convince the market at the launch of the program that it's not QE as all bond purchases would be sterilized, it turned out that only 60.78B euro was drained via 7-day term deposits, leaving almost 13B euro in the money market. We believe this is negative for the euro as the SMP is indeed no difference from QE in the US and the UK.

There have been talks that the ECB will step up liquidity provision and purchase peripheral debts. There's chance for the ECB to expand the scope of it purchases if the situation deteriorates rapidly as there is no limit on the duration or magnitude of the SMP. Should this materialize, the euro will get hammered as investors punish money-printing (like selloff in USD for most of the time in 2010).

ECB's decision in the coming year will be very challenging and opinions from policymakers will be more diverged. While peripheral economies welcome further easing, Germany should object the measures as tolerance of accommodative monetary policies for a prolonged period of time would mean higher inflation for Germany and this would damp the country's competitiveness.

Central Banks Part 1 : The Fed

Last meeting: December 14, 2010

Prior to last: November 2-3, 2010

Next meeting: January 25-26, 2011

Chairman: Ben Bernanke

Meeting Statement

At its last meeting on December 14, the FOMC maintained the “exceptionally low” for an “extended period” language on the Fed Funds rate, keeping it unchanged at a target range of o to 0.25%. The Fed also noted that it intends to continue its planned $600bn of Treasury purchases, $75bn per month as announced in the November meeting up to June 2011. The Fed also cautioned that it would monitor and evaluate the size of the program on an ongoing basis.

Longer-term inflation expectations were seen as stable but underlying inflation has continued to trend downward.

For the nth meeting now, Kansas City Fed President Thomas Hoenig voted against the policy adopting the view that the economic recovery means that an expansionary monetary policy could spark extremely high levels of future inflation that could destabilize the economy.

Prior meeting minutes

Many market participants worried whether the Fed will complete its stated $600bn in Treasury purchases, citing future inflation as a problem. The Fed minutes from the November 3^rd meeting seem to have clarified its strong commitment to this policy. There are in fact reasons to believe that the Fed has potential to do more if required. The minutes from the Fed meeting included an FOMC videoconference on October 15, 2010 at which the members discussed a several possible easing steps, with the announced program described as an “incremental approach” as opposed to the much talked about shock and awe approach. This terminology only suggests that the stated amount of $600bn is very likely seen as a first installment. Given the Fed’s determination towards easing, the economy would need to improve beyond its forecasted 3.3% level, accompanied by a gradually declining unemployment rate. Such developments seem highly unlikely in the next three to six months.

Outlook

The Fed is still facing extremely sticky unemployment, falling inflation measurements, and extremely low levels of household spending and consumer confidence. It seems highly likely that the Fed will continue and complete its planned QE2 program. I do not think a QE3 will take place. The recovery has been slow, but there is recovery nevertheless. The extension of the fiscal easing should make corporates have a more clear planning horizon which should help staffing and capital budgeting decisions.

I don’t see the Fed tightening happening anytime in 2011, even though the market seems to be pricing in a tightening beginning Q2 2011, as implied by the Eurodollar futures for March and June 2011. A tightening of monetary policy in 2012 Q1 seems more likely. On the other hand, with an imminent fiscal tightening in 2012 or 2013 times ahead for the US seem extremely bumpy.

** The voting members rotate beginning next year. The only dissenter, Kansas City President Hoenig will not be a part of the voting team now. Kansas City, Cleaveland, Boston and St. Louis will be replaced by Chicago, Minneapolis, Philadelphia and Dallas. Minneapolis Fed President Mr Narayana Kocherlakota has some interesting thoughts which I hope to discuss here soon.

The Crisis in Bullet Points

How did this crisis happen? How could men earning tens of millions end up losing tens of billions? How could a Republican administration end up nationalizing the federal National Mortgage Association, the Federal home Loan Mortgage Corporation and the insurance giant, American International Group? Above all, how could a crisis in the American mortgage market precipitate not just an American recession but quite possibly a world depression? To answer these questions you need to understand at least six distinct though interrelated financial phenomena:

1. How so many American and European banks came to have such highly leverage balance sheets, in other worlds how they ended up owing and lending so much more money than their underlying capital bases;

2. How a whole range of different kinds of debt, including mortgage debt as well as credit card debt, came to be "securitized", or bundled together and then sliced up into different kinds of bond-like securities;

3. How the monetary policies of central banks came to be focuses on a very narrow definition of inflation, ignoring the potential hazards of bubbles in stock prices and later real estate prices;

4. How the insurance industry, led by the giant American firm AIG, branched out of traditional risk coverage into the market for derivatives, effectively selling protection against highly uncertain financial risks;

5. Why politicians on both sides of the Atlantic sought to increase the percentage of households that owned their own homes using a variety of inducements to widen mortgage markets;

6. What persuaded Asian governments, and particularly that of the People's Republic of China, that they should help to finance the US current account deficit by accumulating trillions of dollars in international reserves.

Recommend: The Ascent of Money, A Financial History of the World by Niall Ferguson

Trade Idea: Long September 2011 Euro-Dollar contract

The sell-off in the September 2011 Euro-dollar contracts after the latest FOMC meeting seems to wrongly price the beginning of the Fed’s tightening cycle. Prior to the QE2 announcement, the tightening was priced in close to the end of Q3 of 2011. This has changed dramatically with the tightening now being priced in close to the end of Q1 2011, as suggested by the March 2011 contract.

The announcement of $600bn in QE2 itself is a stance of easing which should have, if anything, pushed out the tightening cycle of the Fed. There are arguments suggesting that the sell-off was plausible since the Fed has a reasonably strong GDP forecast of 3.3% for 2011, which will probably be enhanced by the QE announcement. On the contrary, I believe the Fed’s tightening will more likely be determined by the unemployment rate. Interestingly, the Fed has revised up its unemployment forecast for Q4 2011 to 9% from 8.5% previously.

Many market participants worried whether the Fed will complete its stated $600bn in Treasury purchases, citing future inflation as a problem. The Fed minutes seem to have clarified its strong commitment to this policy. There are in fact reasons to believe that the Fed has potential to do more if required. The minutes from the Fed meeting included an FOMC videoconference on October 15, 2010 at which the members discussed a several possible easing steps, with the announced program described as an “incremental approach” as opposed to the much talked about shock and awe approach. This terminology only suggests that the stated amount of $600bn is very likely seen as a first installment. Given the Fed’s determination towards easing, the economy would need to improve beyond its forecasted 3.3% level, accompanied by a gradually declining unemployment rate. Such developments seem highly unlikely in the next three to six months.

Of course, it has to be acknowledged that the QE2 program got off to a rough start due to global political developments, market volatility and the Fed’s internal dissent. To address the latter, the “meeting opened with a short discussion regarding communicating with the public”, and the members supported a review of the FOMC’s communication guidelines with the aim of ensuring that the public is well informed about issues in monetary policy, while preserving the necessary confidentiality of policy decisions, until their scheduled releases.

Given this context, I recommend going long the Eurodollar contract for September 2011 expiry.

September 2011 contract

Implied short term rate: 0.705%

March 2011 Contract

Implied short term rate: 0.525%

Current Fed funds target rate: 0% to 0.25%