Investors Are Lab Rabbits in Central Bank ExperimentsRich Miller and Jennifer Ryan
The European Central Bank and Bank of England are emulating Ben S. Bernanke’s experiment in offering monetary-policy guidance to financial markets. Investors could well end up being the guinea pigs.
Bond prices have fluctuated during the last three months, with the yield on the 10-year Treasury note swinging from 1.63 percent to 2.74 percent, the fastest jump since 2010, as the Federal Reserve chairman struggled to provide a clearer picture of when and why the central bank will reduce and then end its asset purchases.
“If this is science, then we’re the little white lab rabbits,” said Vincent Reinhart, chief U.S. economist for Morgan Stanley in New York, who served as the Fed’s chief monetary-policy strategist from 2001 to 2007.
More communication mishaps are likely as the ECB and BOE strive to get their messages across to the market, said Gilles Moec, co-chief European economist at Deutsche Bank AG in London and a former Bank of France official. “The potential for the dialog between the central banks and the market to sometimes fail is significant,” he said.
All three monetary authorities meet separately this week, with the Fed gathering on July 30 and 31 and the ECB and BOE announcing policy decisions Aug. 1.
ECB President Mario Draghi said July 4 that the central bank expected its key interest rates “to remain at present or lower levels for an extended period of time.” The central bank’s main refinancing rate is 0.5 percent while its deposit facility rate is zero.
The BOE, led by new governor Mark Carney, declared the same day that market expectations of tighter credit were “not warranted.” It’s reviewing how it might implement guidance and has said the findings will have an “important bearing” on policy discussions in August.
The U.K. and euro region are adopting the Fed’s forward-guidance strategy in an effort to decouple their bond markets from that of the U.S., said Nathan Sheets, global head of international economics at Citigroup Inc. in New York.
“The U.S. economy is way ahead of the U.K. economy and the euro-area economy in terms of its place in the business cycle and the strength of its recovery,” said Sheets, a former director of international finance at the Fed. “Slightly higher rates in the U.S. were appropriate, but it’s hard to say that higher rates are appropriate for the U.K and the euro area.”
Bond-yield forecasts by Sheets and his colleagues at Citigroup suggest the ECB and BOE will be partly successful in shielding their markets from the influence of the U.S. They predict yields will average 1.8 percent on 10-year German bunds in the fourth quarter of 2014 and 2.75 percent on same maturity U.K. gilts.
The yield on the 10-year bund was little changed at 1.68 percent as of 10:38 a.m. in London. The U.K. 10-year government bond was down 2 basis points at 2.32 percent.
They see a steeper rise in U.S. rates, with the yield on the 10-year Treasury note averaging 3.25 percent in the closing three months of 2014 compared with 2.56 percent at 4:45 p.m. in New York on July 26, according to Bloomberg Bond Trader data.
The euro and pound will lose ground against the dollar as a result, said David Bloom, global head of currency strategy at HSBC Holdings Plc in London. He sees the dollar “powering ahead” by the end of this year, with sterling weakening to $1.45 and the euro falling below $1.25. The former was $1.54 at 4:40 p.m in New York on July 26, while the latter was $1.33.
The Fed began providing forward guidance to the markets in 2003, telling investors that policy could remain easy “for a considerable period” after it cut its short-term interest-rate target to what was then a record-low 1 percent.
The strategy evolved further during the financial crisis and its aftermath as the central bank looked for ways to stimulate the economy beyond reducing the interbank federal funds rate essentially to zero.
In 2011, the U.S. followed the lead of the Bank of Canada - - then headed by Carney -- and adopted a calendar-based funds forecast, saying the rate was likely to remain “exceptionally low” at least through mid-2013.
After extending such assurance twice, policy makers junked this approach at the end of 2012 and instead tied the rate target to specific economic thresholds. It now intends to keep short-term rates near zero at least as long as unemployment remains above 6.5 percent and the outlook for inflation doesn’t exceed 2.5 percent.
Joblessness was 7.6 percent in June, and inflation was 1 percent in May. The economy has grown at an average annual rate of 2.1 percent since the 18-month recession ended in June 2009.
The BOE will respond to Chancellor of the Exchequer George Osborne’s request for an assessment on thresholds and forward guidance when it presents its quarterly economic forecasts on Aug. 7, according to the minutes of the July 3-4 meeting. Any announcement about implementation would be made then, rather than after the next policy decision on Aug. 1.
More than half of 43 economists surveyed this month by Bloomberg News predict the BOE will adopt a data-contingent form of communication. Two in five see it embracing a calendar-based commitment.
Recent Fed research has highlighted the importance of forward guidance in aiding the economy while de-emphasizing the role played by quantitative easing, according to Sven Jari Stehn, an economist at Goldman Sachs Group Inc. in New York. It “is probably the more powerful tool,” he said in July 24 report to clients.
That doesn’t mean the transition will be smooth. Whatever plan the BOE produces, it will have to contend with the difficulty of precommitting its nine independent policy makers, some of whom may be replaced by new officials before the goal is achieved because their terms end.
The ECB hasn’t given details on the length of its “extended period” of low rates, with policy makers offering differing interpretations. This has led to some confusion. Executive Board member Joerg Asmussen said July 9 in an interview with Reuters TV that “it is not six months, it is not 12, it goes beyond,” only to be corrected by an official clarification shortly after that the bank hadn’t provided an exact duration.
Guidance also can erode credibility. Picking an economic variable may create the impression that policy can be boiled down to a single indicator, while a time horizon may fall prey to unexpected events.
“Central banks have no idea what’s going to happen in the future, so to commit yourself to a particular policy stance carries risks,” said Jonathan Loynes, chief European economist at Capital Economics Ltd. in London. “If things turn out to be different, you may have to renegotiate on your guidance, and the result of that is that any guidance given in the future would lack credibility.”
Officials still are willing to try new measures because economic recovery isn’t assured in Europe and could be undermined by rising bond yields.
Gross domestic product in the U.K. is 3.3 percent below its peak in early 2008, before the financial crisis struck, even though growth picked up to 0.6 percent in the second quarter from 0.3 percent in the first.
The BOE already has bought 375 billion pounds ($577 billion) of bonds through quantitative easing, suspending the program at the end of 2012. Policy makers have held their key interest rate at a record low 0.5 percent since 2009. Minutes of this month’s policy decision showed some officials questioned the benefit of more QE.
The International Monetary Fund forecasts the economy in the 17-nation euro area will shrink 0.6 percent this year. Draghi has never used the Outright Monetary Transactions program he created in 2012 to back up his claim that officials are prepared to do whatever it takes to preserve the euro. The ECB cut its benchmark rate to a record-low 0.5 percent in May.
“They’re trying to address the pickup in yields without actually buying bonds,” said Azad Zangana, a former U.K. Treasury official and now an economist at Schroder Investment Management in London, which has $364 billion under management. “Forward guidance has been successful so far, it’s pushed yields back down, but there are limits to how far it can go.”