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Abu Dhabi, UAEMonday 24 September 2018

Newly proactive central banks get markets thinking

New stance by prominent state lenders has caught markets a little bit off guard

European Union flags  outside the headquarters of the European Central Bank in Frankfurt, Germany. Ralph Orlowski/Reuters
European Union flags outside the headquarters of the European Central Bank in Frankfurt, Germany. Ralph Orlowski/Reuters

Central banks have told markets to expect policy changes in the coming months, with the US Federal Reserve, the European Central Bank (ECB) and the Bank of England (BOE) all lining up to tighten monetary policy in various ways.

Adjustment of the Fed’s US$4.5 trillion balance sheet will commence in the United States from October, and it has also been made clear that the Fed has not given up on hiking rates in December despite still subdued inflation. Also in October the ECB will articulate its strategy for tapering its €60 billion (Dh263.5bn) per month bond buying programme, probably starting in 2018. The BOE for its part has indicated that it could raise interest rates as early as November.

The return of policy activism by prominent central banks has caught markets a little bit off guard. The presumption at the start of September was that the Fed was unlikely to raise rates again this year, and may not do so at all in 2018. The BOE was also seen as unlikely to raise interest rates this side of 2018, while it was the ECB that was considered most likely to surprise with its president Mario Draghi under pressure to begin tapering QE.

These assumptions gave rise to a weak dollar and a weak sterling, with the euro in the ascendancy. Other factors also played a role in dampening the dollar including doubts about US legislation through the rest of the year, uncertainty about the debt ceiling and a ratcheting up of geopolitical tensions.

However, the debt ceiling issue has now been pushed out until December, markets have seemingly become desensitised to political risks stemming from North Korea, and US Congress is once again seeking to pass legislation to overturn Obamacare. In this context, the resumption of a more hawkish Fed has allowed the dollar to find its feet again, as expectations of a December rate hike have gone from less than 30 per cent to over 60 per cent in just a few days. This change in mood may in turn not last for long but for now the dollar is stronger than it was a fortnight ago.

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Likewise with sterling, the markets were surprised by the hawkish tone of the BOE’s comments after its last monetary policy committee meeting in the middle of the month. These followed a sharp rise in UK inflation, taking it to its highest levels since 2013, causing the bank to say it would look to withdraw stimulus “over the coming months”. With the BOE, it pays to take such warnings with a pinch of salt as they have been heard before - only for the Bank not to live up to them, giving rise to the governor Mark Carney’s reputation for "crying wolf". However, it would be a very big volte face for the BOE not to raise interest rates in November now. Sterling has become the strongest major currency in September on the back of the BOE’s comments, so the potential is for a big unwind lower should the BOE fail to keep its word.

The euro was the principal beneficiary of the weak dollar and pound in the first weeks of the month. But with the Fed and the BOE perhaps eclipsing the ECB in terms of their recent hawkishness the euro may now struggle, at least until Mr Draghi outlines the ECB’s approach to QE tapering in early October. It might be hoped that he does not talk up the prospect of rate hikes to much as this could push the euro to unwelcome levels back above 1.20, something ECB officials are clearly worried about. The ECB executive board member Benoit Coeure said recently that “exogenous shocks to the exchange rate, if persistent, can lead to an unwarranted tightening of financial conditions with undesirable consequences for the inflation outlook” and that “the recent volatility in the exchange rate represents a source of uncertainty which requires monitoring”.

Some headwinds to growth are already visible in the data as the firmer euro is suspected of being partly responsible for a 1.1 per cent month-on-month fall in euro-zone exports and a 0.7 per cent month-on-month increase in imports in July, causing a narrowing of the euro-zone trade surplus. For the euro zone, therefore, the less Mr Draghi says next month about prospective policy tightening may be for the better.

Tim Fox is Chief Economist & Head of Research at Emirates NBD

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