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Wednesday, 25 February 2009

Commentary by Kathy Lien: Race to Zero Interest Rates

With no US economic data released this morning, we take this opportunity to discuss the Race to Zero Interest Rates. Of the eight major central banks, three have already taken interest rates as low as they can. These are the Federal Reserve, the Bank of Japan and the Swiss National Bank. Further interest rate cuts are expected from the other central banks but the question is who will win the race. In this competition, getting to the finish line quickly is not as important as getting there eventually. Not every central bank is expected to take interest rates to zero but at bare minimum it is interesting to talk about how many more rate cuts are expected.

The Federal Reserve – Onto Credit Easing


Growth: There is no question that from a growth perspective, the outlook is the US economy is bleak. More than 6.5 million Americans are claiming unemployment benefits and the unemployment rate is expected to rise to anywhere between 8.2 and 8.8 percent. Consumer spending has been weak and will continue to remain so as long as Americans are losing jobs or struggling to hang onto them. If interest rates did not already hit rock bottom, the central bank would be responding with aggressive rate cuts now. Any improvements that we have seen in the US economy is suspicious as every knows more trouble lies ahead. President Obama signed a $787 billion economic stimulus package. This will eventually help the US economy but it may be some time before the stimulus reaches the pocketbooks of Americans.


Inflation: In the month of January, both consumer and producer prices increased. However, despite the moment of optimism elicited by the monthly report, the annualized basis of CPI fell to 0%, the lowest price level in thirty years. Certainly, this fact is enough to declare that inflation is not a concern while and disinflation, a step above deflation is a very real possibility. Across America, we are already seeing price cuts in many different industries.


Central Bank Comments: In a recent speech given by the Federal Reserve Chairman, Ben Bernanke, cited the fact that inflation will remain low for some time, but resisted temptations to use the term deflation. In order to give the market some identifiable metric, Bernanke choose to set an inflation target of about 2.00 percent, far above the current plight in consumer prices. The Fed is currently embarking on Credit Easing which is very similar to Quantitative Easing which involves pumping money into the financial system by purchases assets like commercial paper and agency mortgage backed securities.


Outlook for Interest Rates: The Federal Reserve has run out of room to cut interest rates. With a target range of 0 to 0.25 percent, they are basically at zero. The only reasons why they didn’t take rates down to 0 officially is because it would be psychologically crippling and they did not want to threaten the viability of money market funds.



European Central Bank – Reluctantly Taking Rates to 1 Percent



Growth: Like the US, recession has hit the Eurozone. The difference however is that in addition to weaker growth, the Eurozone is vulnerable to further problems in their financial sector. Western European banks have extensive exposure to Eastern European nations. If borrowers from those nations default on their loans, there could be a domino effect on the Eurozone. Ireland is also at risk of default and if that occurs, it could an exodus out of Euros.


Inflation: Unlike the US, prices are falling and not rising in the Eurozone. The European Central Bank acknowledges that price pressures are easing, yet they are reluctant to aggressively cut interest rates and instead regularly warn about taking rates to ultra low levels.


Central Bank Comments: Jean-Claude Trichet has not been quiet about his desire to at least slow-down the magnitude of easing until the stimulus has time to filter through the system. Last month, he left interest rates unchanged at 2 percent. Most recently, Trichet is quoted as saying that he will provide an unlimited amount of cash for the euro-regions bank. It is possible that he will resort to using these liquidity measures rather than accelerated rate cuts to manage monetary policy. Trichet also holds that the threat of deflation is minimal.


Outlook for Interest Rates: The ECB will continue to cut interest but will probably stop at 1 percent. A 50bp rate cut is expected last month and Trichet has already confirmed that these are well placed expectations.


Bank of England – Rates Headed to US Levels, Adopting Quantitative Easing


Growth: The UK is in recession with growth currently running at minus 1.5%. The labor market is deteriorating, but consumer spending has been resilient. Problems in the housing market and the financial sector have hit the country hard and therefore the Bank of England expects weak growth to last for the next few years.


Inflation: Deflation concerns in the UK are probably the least prevalent out of the major central banks. Annualized CPI in January was 3 percent. The weakness of the British pound has driven Producer Prices higher but the BoE believes that inflation will undershoot their 3 percent target significantly this year. In their recent Quarterly Inflation report, they forecasted inflation to slow to 0.5 percent within the next 2 years. This will support their plans to keep monetary policy easy.


Central Bank Comments: Bank of England Governor King is very pessimistic about the outlook for the UK economy. Two weeks ago, he warned that the UK economy is in deep recession signaling that interest rates are headed lower. The minutes from the most recent monetary policy meeting revealed that central bank officials were reluctant to cut interest rates more aggressively even though their economic outlook was negative. They were not reluctant however to appeal to the Chancellor for the authority to embark on Quantitative Easing by starting to buy Gilts.


Outlook for Interest Rates: At their next monetary policy meeting in March, the BoE is expected to cut interest rates to 0.5 percent and officially begin Quantitative Easing. Their efforts to cut interest rates have been ineffective in stimulating the economy. King already had an initial meeting with Chancellor Darling and given the market’s expectation for QE, the Chancellor should oblige. The BoE could still take interest rates to zero. With US rates already at that level, the stigma of moving to ZIRP is not as significant.


Bank of Canada: Interest Rates Could be Headed to ZIRP

Growth: Canada is only beginning to feel the effects of the US recession. For the first time in 30 years, Canada reported a trade deficit. Weaker demand for auto exports and lower oil prices have dealt a double blow to the Canadian economy. In the month of January, the unemployment rate hit a 4-year high. Consumer spending is beginning to crumble and the recession is expected to deepen. The central bank expects growth to contract by 4.8 percent in the first quarter.


Inflation: Inflation is falling in Canada. Consumer Prices fell for the fourth consecutive month, putting the country at risk of deflation. The decline in oil prices is expected to drag the annualized pace of CPI growth below zero in the fourth and third quarter.


Central Bank Comments: Mark Carney, the Governor of the Bank of Canada shares our concern about inflation. After cutting interest rates in January, Carney said that he still has “considerable flexibility” to take further action. He believes that growth will not start until early 2010, but when it happens, it may be sharp.


Outlook for Interest Rates: Canada is probably the most likely central bank to take interest rates to zero. Another 50bp rate cut is expected in March. Their economy is just beginning to slow and the BoC will have to step up to the plate by cutting interest rates more aggressively.


Reserve Bank of Australia: Lucky Enough to Skirt Recession


Growth: Australia is one of the few countries lucky enough to not be in recession. Growth is currently lingering at very low levels, but has not since dipped into negative territory. The country has been showing varied levels of stabilization including a bounce in Retail Sales. Even though the Unemployment Rate rose to 4.8 percent, Australia is still reporting job growth, to the envy of their global counterparts.


Inflation: Despite the pleasing picture of Australian growth prospects, inflation is still retreating. Producer Prices have fallen to 1.3% while Consumer Prices were pushed down to -0.3%. The negative consumer price figure does create a certain disinflation concern and the decline in commodity prices could keep price pressures depressed.


Central Bank Comments: The members of the RBA have been expressing certain optimism about the prospects of their economy. Most recently, Deputy Governor Edey said that Australia would outperform because of the tremendous amounts of monetary and fiscal stimulus injected into the economy Combined, Edey belives that these forces should keep the country out of recessionary. Glenn Stevens, the central bank head, reiterated Edey’s comments by saying that the economy will recover as quickly as the end of 2009.


Outlook for Interest Rates: It may be true that the RBA continues their easing measures to some extent. However, since there is such a large buffer at 3.25%, there is little chance that conditions will worsen to the point where zero interest rates are warranted. In addition, the content attitudes of the RBA, signifies that the large cuts will no longer be the stable of policy decisions. For Australia zero or even 1 percent interest rates is out the question.


Reserve Bank of New Zealand: More Weakness, More Rate Cuts


Growth: Unlike Australia, New Zealand was one of the first countries to fall into recession. Despite aggressive rate cuts, they have not been able to engineer a recovery. The high beta country is still very sensitive to world developments. The only saving grace is that the weakness of the New Zealand dollar is boosting tourism. As for domestic demand, it remains weak with retail sales falling 1.0 percent. Employment on the other hand is mixed with a positive surprise in employment change but a big jump in the unemployment rate.


Inflation: Like other commodity currencies, New Zealand has faced an accelerated decline in prices. Producer prices have fallen an amazing 7% in three quarters, landing at about -2.2% in the most recent report. Consumer Prices have likewise faced pressures that have pushed inflation down to -0.5%. There is a very real threat that, as the result of the declines in commodity prices, New Zealand may experience deflationary conditions.


Central Bank Comments: Recent comments by Reserve Bank of New Zealand Governor indicated his concern over the lending conditions in the country, urging households and firms not to “pull down the shutter” and limit economic activity. He also adds that he feels that inflation remains under control despite the strong pull back in consumer prices. In late January, Bollard mentioned that the “toolbox” is by no means empty, indicating that further rate cuts can be implemented. Finance Minister English believes that there is more trouble ahead for the New Zealand Economy.


Outlook for Interest Rates: The RBNZ has way too much breathing room when it comes to cutting rates. With the highest interest rate among the 8 major countries, New Zealand has plenty of room to ease. Another 50bp of easing is expected but conditions would have to alter severely for the central bank to take interest rates to 1 percent, let alone zero.


Bank of Japan: Quantitative Easing Take 2


Growth: Growth concerns in Japan have hit the spotlight with annualized GDP showing a staggering drop of more than 12.0%, the largest contraction in more than three decades. This figure is enough to single-handedly describe the deterioration of the economy over the last year. Japan’s woes are very closely related to the unrelenting strength in the yen, which has posed a 15% gain against the dollar since its highs in August of 2008. As an exporting dependent economy, the combination of the weak international demand and strength in the currency has brought the region into recession. Their Trade Deficit has enlarged to -¥197.9B, a more than 100% increase over the prior month.


Inflation: Historically, Japan has held a very low inflation rate. This was one of the primary characteristics that followed them through a decade of stagnate growth. Currently, Tokyo Consumer Prices are on the move downward along with National Consumer Prices. The threat of deflation is a very real possibility for the region and could prove to further exaggerate the effects of their recession.


Central Bank Comments: In a report released by the central bank, current consensus indicates that “economic conditions have deteriorated significantly”. The BoJ Governor himself said that economic prospects are “extremely uncertain”. In response to these conditions, Masaaki Shirakawa announced a new extension to his asset purchase program that will now include corporate bonds. He concluded that despite these efforts, corporate lending will most likely remain depressed.


Outlook for Interest Rates: The BoJ’s target rate is too close to zero to pose the probability of further rate cuts. The 10bp buffer that they have left is merely a psychological amount as the central bank went to great lengths to stress that they are not returning to a zero interest or quantitative easing policy. In our opinion however, they will probably remain in the zero rate club for some time.


Swiss National Bank: Leaving Room to Cut Rates to Zero


Growth: Even though Switzerland has deployed recession-like monetary maneuvers, the region has not officially been sunk into the technical definition of a recession. Third quarter GDP fell to 0.0%; the next report is expected in early March. The KOF Economic Barometer has been retreating for a total of fifteen months. Retail Sales on the other hand made a comeback in the month of January, coming in at 3.6% versus -1.4% in the prior month.


Inflation: Deflationary concerns have been on the rise in Switzerland as well. Consumer Prices fell again to -0.8% from -0.5%. Producer Prices reflect similar levels. The fact that the price level has been negative for an extended period of time may mean that the region is currently experiencing some of the same symptoms.


Central Bank Comments: John-Pierre Roth, the head of the Swiss National Bank, seems confident that he we continue cutting rates, indicating that the target in 2003 was only 0.25%. At this level, it is pretty much a certainty that rates have reached the bottom. Others in the bank, like Thomas Jordan, have indicated interests in starting bond purchasing programs or even foreign exchange intervention. However, Roth has indicated that the effects of rate cuts will take time to push libor rates to the same level.


Outlook for Interest Rates: The SNB is definitely one of the few central banks that we suspect will actually make the move of taking interest rates to zero. The central bank has been very unhappy with the recent appreciation of the Swiss Franc and therefore cutting interest rates further could take some steam out of the currency.

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