Policy Update: Looking at the Gaps

As you will probably read, I have been an ardent bull if the Euro vs the USD for few years (though bullish overall since 2002). It was purely a technical call and had nothing to do with the "pending collapse" of the US economy, as many bears will have you believe or the housing bubble. Just quantitative metrics and a few charts to boot. Anyhow, one of the metrics that favored the Euro over the dollar was the policy gap. The policy gap, as I term it, is essentially a measure of how easy or tight overnight policy is for a given central bank. At this point, I only follow three central banks for this metric: The European Central Bank, the Bank of England and the US Federal Reserve.

I find the policy gap to be very helpful in many ways from a trading perspective. Of course if I gave you all of those "ways" I might be giving away state secrets so I will just give an update of these gaps each week or from time to time along with the implications for such policy. Here is the first installment of "Policy Update: Looking at the Gaps."

ECB Now Tight (Fair Value of Repo Target: 4.08%)
With its latest rate hike of 25 bps a few weeks back, taking the overnight repo target to 4.25%, the ECB adopted an overly tight stance on policy. Many in the marketplace questioned this move and honestly, so did I. This move reminded me of our Federal Reserve in 2000 when it raised rates essentially giving the markets a punch in the gut and creating or hastening the greatest equity market plunge ever in the Nasdaq. Since this move by the ECB, financial markets have been in flux and stocks have been mostly falling. Did they make the right move? Well, if gold is any indication lately, these merry men may have jumped the gun as I think inflation is about to roll lower and not higher in the Eurozone. This means that rate policy will have to come down in the future - this implies that the Euro may be in trouble as a result.

Fed and Easy Money (Fair Value of Repo Target: 4.67%)
So lets me guess. You took a double take when you saw where I think the overnight Funds target should currently reside? I bet you did. From what I can see in my forecast, the funds target needs to come up to this level and hikes should start soon. Interestingly though in the 2000 to 2002 period, the gap was just as wide and the Fed dropped rates even further taking the overnight target down to 1%. Now with 2.67% of funds hikes needed, does the Fed hike at this juncture? Well Plosser was pretty adamant about raising rates but I think the Fed may have something working for it: the correlation between the PCE and CPI. Essentially, they are moving in opposite directions with the CPI higher and the PCE lower. This reveals shrinking margins in the corporate world. Weaker earnings in the corporate world will lead to lower demand as people are layed off. Historically the Fed does not make a habit of raising rates in such an environment.

So what are the implications? Well, I think once the market realizes that the ECB needs to cut, the Euro could be in for some major correction. When and where is the question. I will be out with a currency update in the days ahead.