US Fed - Walking a Tightrope

Yield Spread Analysis 02/27 – 03/06
Yield curves in many countries have flattened over the course of the week on flight to safety following the crunch in the equity markets. The result? Short term rates have been driven lower while longer term rates have held fairly steady, with the exception of Canada. However, the moves haven’t been substantial on a weekly basis as the stabilization of equity and FX markets have led yields to rebound higher today.

In Canada, economic data has proven to be quite optimistic, as Q4 GDP hit the tape stronger-than-expected last week. Although the Bank of Canada decided to leave their benchmark steady, the policy statement had a slightly hawkish bias and provided a decent boost to 10-year yields.
Looking ahead, risk aversion could continue to be a bond market mover and keep yields weighed down. Meanwhile, the European Central Bank is anticipated to hikes rates this week, but traders have clearly already priced this in. The market is skeptical about the rest of the year, and yields could be sent reeling if ECB President Trichet rings an unexpectedly hawkish or dovish tone during the press conference following the rate decision.

Long Term** vs. Short Term*

BOJ – Unfazed By Unwinding
Central bankers and political officials aren’t overly concerned with the recent surge in yen and plunge in equities, but how long will they patiently watch before considering intervening?

[U]Toshihiko Fukui, Bank of Japan Governor

[/U]“We are looking with strong interest, but calmly, at how stock prices will move ahead.”

Hiroshi Watanabe, Japanese Vice Finance Minister for International Affairs
“Traders do not appear to be rushing en masse to unwind yen carry trades.” – March 2, 2007
“The recovery of the economy is sustained and led by the private sector. There is a good amount of household consumption.” – March 1, 2007

Koji Omi, Japanese Finance Minister
“Japan’s economy is recovering smoothly on stable prices.” – March 5, 2007
“Exchange (rates) and stock prices are decided by markets. I won’t comment on levels, but I’d like to keep a close eye on them.” – March 6, 2007
IMF Director Rato, however, sees a bit more danger in the scenario:

Rodrigo Rato, International Monetary Fund Managing Director
“I don’t think they (carry trades) are a danger in the sense that they reflect investors’ analysis of opportunities in the market. I think what investors need to be aware of is that the carry trade has downside risks. I think investors should be aware that even in a very benign scenario, downside risks exist and they appear once in a while.” – March 1, 2007

“A disruptive unwinding of carry trade positions occurred in October 1998, when the U.S. dollar fell by 15% against the Japanese yen in four days. I am concerned that investors and the countries into which funds are flowing are not sufficiently attentive to the risks.” – February 27, 2007

US Fed – Walking a Tightrope
The Federal Reserve has certainly taken on more cautious tones regarding the economy but has also signaled that the markets are on their own, as the central bank can only use monetary policy to prevent inflation:

Ben Bernanke, Federal Reserve Chairman
“My view is that taking all the new data into account, that there is really no material change in our expectations for the US economy since I last reported to Congress a couple weeks ago. The Fed is closely monitoring the markets and they seem to be working well, normally. We are looking at moderate growth in the US economy going forward, and there is a reasonable possibility that we’ll see some strengthening of the economy sometime during the middle of the year.” – February 28, 2007

William Poole, St. Louis Federal Reserve Bank President
“We do not see a recession coming. I think the probability is a little higher than it might have been two years ago. But the prevailing forecasts certainly do not include a recession in the US economy.” – March 2, 2007
“Price stability must be the paramount objective for monetary policy?without it, goals of maximum employment, moderate interest rates and financial stability will be more difficult, if not impossible, to achieve.” – March 5, 2007
“My way of stating my comfort zone is core inflation of 1.5 percent per year, plus or minus a range of 0.5 percent to allow for unavoidable short-run.” – March 5, 2007

Randall Kroszner, Federal Reserve Governor
“Fortunately, the financial markets seem to be working well and there seems to be sufficient liquidity in the system to respond to the rapid changes that have been occurring recently. The numbers do suggest stabilization in the housing market recently. But whenever there is a market that is in transition, there is always some uncertainty about that direction.” – March 6, 2007

Timothy Geithner, New York Federal Reserve Bank President

“Central banks cannot realistically hold out the prospect of using monetary policy to prevent asset bubbles, conditions of ‘excess’ leverage in parts of the financial system, or other factors in markets that might lead to the types of positive feedback dynamics that were at the heart of some past crises.” – February 28, 2007
ECB – Looking Beyond March
All bets are on monetary policy tightening by the European Central Bank this week. The question is: how neutral will their outlook become and what will it do to the euro?

[U]Jean-Claude Trichet, European Central Bank President

[/U]“The decisive contribution the ECB’s single monetary policy makes to the smooth functioning of economic and monetary union is to maintain price stability – and be credible in the deliver in the future – in the Euro area as a whole.” – March 1, 2007

Axel Weber, European Central Bank Governing Council Member
“The Euro-zone economy is on a solid and stable course of growth which no longer needs an accommodative monetary policy. We must therefore withdraw the stimulation that monetary policy is providing for the economy. The economy will continue to develop favorably even without the help of monetary policy.” – February 28, 2007

[U]Juergen Stark, European Central Bank Executive Board member

[/U]“There is a good chance that the annual average rate of inflation this year will be below that seen in previous years. In the short term, the outlook has brightened. But our task as a central bank is to keep an eye on medium-term price developments. And there are indications that prices would rise sharply again.” – February 28, 2007

[U]Jean-Claude Juncker, Euro Group President

[/U]“Wage developments are moderate. If wages continue to develop in line with productivity, wage increases will not give rise to any inflationary problems, nor will there be any loss in productivity.” – February 27, 2007

Guy Quaden, European Central Bank Governing Council Member

“The level of interest rates is not hampering investment in the Euro-zone.” – February 27, 2007