Policy Update: Going Down

What a horrible week if you were long the Euro or the Pound versus the good ole greenback? I argued every time on this site since launch that the dollar rally was here and everything that was trading against it would lose. Well, the markets spoke this week and in the process ran over anything that had a negative correlation to the dollar. The Euro and Pound have been smacked very hard to the downside. Gold is trembling and the crude market is coming off as perhaps the rest of the world now will face higher real energy prices, like we have in the US. Just in case your are wondering, that is deflationary to growth globally as people globally demand less as prices rise. Aside from this, we also had some economic news this week that effects my policy models so without waiting much longer, here is my policy update for this week.

Summary
Globally overnight policy fair values, as shown on the chart, have been coming down all year. The Federal Reserve has jumped out in front of this trend by dropping rates aggressively. The Bank of England on the other hand cut a small 25bps earlier this year but still lags overall policy tremendously (leaving UK conditions tight by almost 100 bps). The ECB actually tightened rates to 4.25% earlier and as of today, they are now sitting in a very tight policy stance. Based on latest estimates, the Fed is easy by 200 bps, the EU is tight by 5bps and the BOE is tight by 98bps.

United States (Bias: Neutral, Policy: Dovish by 200 bps)
The Federal Reserve has been barking of late about higher policy but that really has not done much to the forward futures contacts. One hike is priced in at the moment to 2.25% within the next 6 months. Beyond that, given the now downward momentum in the overnight fair value calculation, I would imagine that till this reverses course, the Fed may hang out and wait for things to stabilize in the commodity markets. The CPI this week pushed up my calculations but the overall growth picture, at a mere 1.48% year over year (my estimate, not using quarterly numbers but the numbers of dismal.com), the momentum is to the downside. Also, Bernanke was scared about the Shadow Banking system and its effects on prices to the upside last year. I would imagine he is wondering how much downward pressure it puts on the economy in the coming months.

Eurozone (Bias: Neutral, Policy: Hawkish by 5 bps)
The European Central Bank is sitting on its hands at the moment watching as its economy slows down and its inflation rate sinks. Ok, the headline was much higher than expected this week but the core rate is coming down and not rising. Based on current variables, if the growth figure for the Eurozone comes in at 1% and inflation sinks further, the ECB may have to get aggressive with policy to the downside just to stem the fall off in output. However, the ECB will probably not do that because they are so focused on headline inflation. And with a falling Euro, import prices are about to rise for crude goods (crude in dollars all of a sudden more expensive). So they watch for these variables to scare them and meanwhile the real numbers that they should be watching (core inflation and growth) march towards zero. This remind me much of the Fed during the early part of this decade under Greenspan. He held the line on rates with headline inflation higher and guess what? Assets compressed everywhere. Does that sound familiar?

United Kingdom (Bias: Neutral, Policy: Hawkish by 100 bps)
BOE Governor King is in a bind. If he cuts rates with retail price inflation at 4.4%, then he not only irritates the queen and the prime minister but he also perhaps stokes inflation higher in the eyes of many economists (not mine). I read somewhere that it is very possible that the UK could have 0% growth and 5% inflation - no wonder they are sending the pound down the crapper! Overall, I would argue, even with the 4.4% price inflation, they can cut rates by almost 1%. Given the global deflation in the shadow banking system globally not to mention the international stock markets getting slammed, inflation in the UK would not become a problem to the upside as long as they get back to neutral. Now in order to jump start growth, they may need to get easy with policy but that won't happen till the RPI drops under 3%. Till then, I am afraid that Gov King and his merry men may also sit on their hands and send the UK economy into its worst state in decades. Only then will the react and then they'll have a new problem - deflation.