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By Jane Foley
This weeks meetings of the Federal Reserve, the Bank of England and the European Central Bank have focused attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of these policies. Fear that the market has become dependent on the cheap funds plied by the central banks has resulted in a rise in uncertainty about what the economic future will bring. This has underpinned a reining in of risk appetite which in turn has brought some long awaited support for the USD. As announced a month ago, the Fed last week ended its USD300 bln treasury bond purchasing plan; though it will carry on buying mortgage backed securities. The Bank of Japan last week announced that it will stop buying corporate bonds at year end. The Reserve Bank of India also removed emergency support measures last week. Bundesbank President Weber last week suggested that the ECB may not carry on with its 12 mth cash tenders into the New Year, though one more is scheduled for this year. By contrast, the shockingly poor UK Q3 GDP data (-0.4% q/q) increased calls for the BoE to increase its quantitative easing plan at this Thursday's MPC meeting. While this appears to set BoE policy in a contrasting direction to other central banks, any further rise in QE this week could be the last gasp of this policy. Coinciding with the rise in calls for an increase in QE has been an apparent increase in scepticism about the effectiveness of the plan. While proponents of QE view the lacklustre growth in money supply and subdued inflationary pressures as suggesting there is more room for QE. It could equally be argued that the lack of response in money supply and CPI offers evidence that the plan is having insufficient impact on the real economy. At the same time the availability of cheap money has fuelled the profits of many investment banks. It will take many more months before the true impact of QE can be ascertained but it seems possible that the BoE may see declining benefits of extending this plan much beyond the turn of the new year. That said, with market confidence already horribly shaken by the poor performance of the UK economy in Q3 and by difficulties still faced by some banks, in particular RBS, the Bank of England like other central banks will have to tread carefully when withdrawing QE. A slow winding down of this scheme seems the most likely outcome. This suggests that a relatively modest GBP 25 bln step up in the plan is likely to be announced this week. Insofar as this is priced in, sterling should see little immediate impact from such a decision although until expectations for growth in the UK catch up with those of Germany and France, EUR/GBP is likely to retain its present elevated levels. If central banks do draw the conclusion that the impact of QE on the real economy is limited, these polices could be all but gone in the next few months. That said, the central banks will have to play their hands carefully. A reining in of risk appetite caused by policy decisions may not be unwelcome if it curtails speculative flows. However, central banks need to support business and consumer confidence. Given that QE will, at some point have to be reversed there is every risk that interest rates in the US, UK and Eurozone will remain low at least until the latter half of the year. The present very low level of Fed interest rates has supported the use of the USD as a funding currency. The decision to move from the USD into risky assets, however, has also been a function of strong growth in risk appetite evidence. In turn this has been supported by the very generous provision of cheap funds from the central banks which would be tapered in if QE is halted and eventually reversed. While economic growth is likely to have returned to most of the world by next year, growth projections for most of the G-10 remain fairly modest. This view also suggests that the growth in risk appetite should be reined in going forward. While further medium-term losses for the USD cannot be ruled out, it is possible that the USD will benefit from a tapering in of risk appetite over the next few months. The 75.00 level could continue to rein in losses for the dollar index near-term and a period of sideway trading in EUR/USD looks likely. For Today's Market Update from the FOREX.com Global Research Team, click here
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