A Policy "Twist" is Better than None

BBH CurrencyView

  • European market consolidates ahead of FOMC decision; GBP softer after potential for QE increases
  • Operation Twist is likely to be supportive of the dollar; dovish actions include QE and inflation target
  • Hungarian central bank likely to offer FX reserves; Brazil CPI surprises to the upside, CBRT dovish

European equities are trading softer ahead of the FOMC meeting in keeping with the more cautious tone into the Wall Street close and Asian exchanges overnight. The Dax is down 1.1%, weighed down by industrials, financials and basic materials with no-one in the market expecting the FOMC to deliver any silver-bullet solutions today. The S&P 500 Dec’11 contract is up modestly by 2.80, but remains short of the 1200 mark at 1198 last. USTs have come into some modest profit-taking at the long end, after 30yr yields collapsed 10bps to 3.242% in the past week on expectations that the Fed will announce an Operation Twist. Short sterling futures are up 2-4 ticks following the dovish set of BoE MPC minutes overnight which signaled growing support for QE2. Front month oil contract is down 0.5%. Canadian CPI accelerated to 3.1% in July, exceeding expectations.

Today, while the euro zone sovereign debt crisis is likely to continue to remain in the back of most people’s minds, the Fed the moves into the limelight following its extended two-day policy meeting. And although US economic data continues to suggest a modest improvement in the H2 from H1 (consistent with the improvement of US economic data surprises that appear to have bottomed out in June), the Fed is not likely to sit by idly with the unemployment rate above 9% and an output gap showing an economy growing at nearly 6% below its potential. We continue to expect that the Fed has at least three available policy options that are possible, given the desire to build a consensus around any announcement at today’s meeting. That leaves us with “Operation Twist”, a cut in the rate on banks’ excess reserve holdings (IOR), and more long-term asset purchases. Some observers suggest that the Fed is flirting with the notion of an inflation target but we suspect that given the Fed’s desire to build a consensus around a policy tool and still elevated levels of inflation, further QE and an inflation target are out of the question for now. Of these options, duration extensions seem the most likely, with the low probability of a cut in IOR from 0.25%. And while the goal of any further policy action is expected to improve financial conditions what would be the potential impact on the dollar? Some observers suggest that further policy action is likely to be negative for the dollar but we strongly disagree. Taken together, an announcement in line with our expectations for Operation Twist would generally expected to be more positive for the dollar. Reason being, is that Operation Twist is just a duration shift along the yield curve and therefore would not lead to an expansion of the balance sheet. What’s more, with the 2-year yield already at record lows a duration shift is likely to send the front-end of the curve marginally higher, which in turn is also likely to be more supportive of the dollar through the relative 2-year yield spread. Otherwise, we would expect further aggressive policy action, such as an extension of QE or an outright inflation target, to be negative for the dollar, although it would likely boost risk appetite and growth sensitive currencies.

The Hungarian central bank said it is ready to offer FX reserves to lenders if needed for settling foreign currency loans. We assume this would be part of a burden sharing plan. We know the banks are going to be on the hook, suggesting that the authorities are willing to bear some of the costs. Of course, borrowers should feel some pain too. We think it’s a work in progress and they are floating a ton of trial balloons. Meanwhile, CB gov. Simor was very dovish in his comments. Domestic absorption to remain subdued, economy to stay below potential in 2011 and 2012, fiscal policy to "significantly" hamper growth in 2012. And yet it discussed a 25 bp hike, and we’re guessing the weaker forint was the only reason. As such, we shouldn’t expect any kind of rate cut in Hungary as long as the currency is under pressure. Elsewhere, we saw higher than expected Brazil IPCA m/m print, which took the y/y rate up to 7.33% from 7.10% in mid-aug. Target range is 2.5-6.5%, central bank is predicting that inflation converges back to 4.5% target by end-2012. We have a hard time seeing that. The future market is pricing is nearly 125bps by Q1 2012, with the odds of a 50bps move in October currently at 66%. Think that’s way too aggressive but if they do cut that much, forget about that inflation target for a while. Meanwhile, in Turkey the CBRT remained on hold but was explicitly dovish. In fact the CBRT continues to see downside macro risks and has indicated that it stands ready to ease policy, should financial stress intensify. Some observers suggest that with the conditions in the EMU likely to deteriorate before they get better, it is only a matter of time before the CBRT is forced act to stimulate the economy. Next step is a possible cut to reserve requirements.

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