My post on February 2, “Is the European Central Bank Truly Fighting Inflation?" will prod readers, especially those convinced that inflation is a real threat, to ask “what is this guy smoking?” when the media at large continues to play the same monotonic ballad. If I may quote myself:
Jean-Claude Trichet, the president of the European Central Bank, has a love affair with fighting inflation and his shift from the debt crisis to the "I" word did wonders for the euro — at least for now. With the latest European CPI number screaming a “frightening” 2.4%, Trichet is looking into his closet and polishing his “weapons of price destruction.” Does he have a point? Not really, but he’s savvy, and I view him as a master of public relations and manipulation. His objective is to draw attention away from the issue at hand while lending credibility and strength to the euro to attract much needed capital, not fight inflation.
The threat of inflation on the horizon is non-existent and Mr. Trichet said it, although not in so many words. Those that understood the message played along and are quietly positioning themselves, without going on financial cable channels and divulging the big "secret." At times it’s difficult to discern the meaning of a message. But in this case the clues are included in the statement- although the main headline scrambled it for some analysts that missed the point.
William Watts at MarketWatch started his article by stating that “Jean-Claude Trichet reiterated an important lesson to currency traders this week: The European Central Bank doesn’t bluff.” Then Mr. Watts documented the market reaction to the euro exchange rate by writing:
But the biggest mystery for some strategists was why the euro didn’t rally even more emphatically in the wake of Trichet’s bombshell. To some, the answer is Trichet’s statement that an April hike won’t necessarily be the start of a “series” of rate hikes. But others say the answer may have more to do with worries the ECB is repeating the mistakes of 2008, when it delivered a July rate hike as the euro-zone economy moved into recession.
They are absolutely correct when stating that the Euro had an extremely muted reaction considering that
The ECB president shook up the financial markets on Thursday by signaling the central bank is virtually certain to raise interest rates next month.
Ajay Chopra, the deputy director of the IMF’s European department, quickly warned against European tightening, although he conceded that “he had not had a chance to study the comments made by ECB President Jean-Claude Trichet.” At this time I cannot tell Mr. Chopra’s position, and may very well be that the IMF has no clue as to what the ECB is doing. Furthermore, Portugal is expected to cave in around April, and that’s no big news.
But let’s cut to the chase and focus on the issue at hand. The contradicting message can be found within the report published by iMarketNews. It's not a “secret” if one pays close attention to the content and puts everything in context with current market dynamics.
The HICP forecast for 2011, as expected, was raised significantly on the back of higher oil and commodity prices to a midpoint of 2.3%, well above the ECB's comfort threshold of 2.0%. This compared with 1.8% in the staff's previous forecasts published in December and is due to sharp increases in the price of oil and other commodities since then. The 2012 projection, which is more indicative the medium-term trend the central bank is monitoring, shows inflation dropping back to 1.7%, which is still above December's forecast of 1.5%.
What's wrong with this statement? Absolutely nothing because it highlights that the ECB knows that deflationary pressures, not inflation, are built into the system. The pre-increase announcements are not directed at fighting inflation. If anything, they are an ackowledgement that oil is playing a temporary part in the equation. If the ECB raises rates by 25 basis points to 1.25%, how does that result in inflation expectations dropping from 2.3% to 1.7% in 2012, before the increase actually takes place? A rate increase takes 6 to 9 months to work itself through the system.
The only possible explanation is that the next increase is a first in a series. However, the muted reaction to the euro is not supportive of that reasoning and the economic barriers are extremely well known. In addition, the 2012 forecast “is more indicative of the medium-term trend the central bank is monitoring” and certainly questions the whole charade, simply because the projection is below the target.
Furthermore, why would the ECB even mention 2012 inflation in the same sentence? To reduce inflation by 0.6%, the minimum bid rate would need at least four increases — if not more — to have that effect, and the current European economic condition cannot absorb the impact, especially those countries on life support. One cannot forget that a rate increase by the ECB filters through every single European member, regardless of the fact that they have different monetary, and more importantly, fiscal policies. In addition, there’s the export factor. Germany, in particular, will not be very cheerful with a higher euro.
A major difference between the HICP (Harmonized Index of Consumer Prices) and the CPI is that the former does not include owner occupied housing and the CPI includes a rental-equivalent cost. Whether the values are correct or not is external to this issue. The point is that although house prices are still on a down slope in Europe, the ECB expects lower inflation even without considering house values.
Over the last 12 months, the Euro hit the interim high at $1.4276 (continuous contract) on November 4, 2010. The interim low point of $1.1874 occurred on June 7, 2010 — a range of 24 cents. My opinion is that the ECB, for whatever reason, likes the $1.40 value, and we are within spitting distance of that target. Thus, the question becomes whether Trichet is serious about fighting inflation and will ratchet rates up, driving the Euro higher, or is he bluffing and playing mind games.
Over the weekend Oli Rehn, the European Monetary Affairs Commissioner, reminded us of the ongoing troubles when he stated that Greece and Ireland need cheaper loans, as reported by Reuters. "I urge the Bundestag not to lose sight of the continuing difficulties in financial markets... several euro zone states are still in danger, he added." This serves to bring into question Jean-Claude Trichet’s chess move and bring forth the seemingly forgotten sovereign debt crisis.
But maybe Oli’s message wasn’t part of the scheme. ECB Executive Board member Jose Manuel Gonzalez-Paramo said in an interview with the Spanish newspaper El Mundo on Sunday, as reported by Reuters, that "If the ECB was devoted to countries with slower recoveries, it would not be able to ensure price stability over the medium term." This reinforces the idea of an April rate hike to some, or pleads for capital inflows to others.
Lastly, Mr. Trichet’s has yet another factor to consider, and that is his legacy. Maybe like Greenspan’s perfect timing on his retirement in 2006, right before the U.S. hit a brick wall — and he knew the depth of the problem — Trichet is ready to pass the torch of misery to the next president of the ECB. He knows full well the true condition of European economic affairs and is trying to float the boat until his term expires in October. If all else fails, he can always resort to offering free toasters to attract capital.
Then on Monday, and according to MarketWatch, Barclays Capital revised its forecast.
Barclays Capital revised up its forecast for the euro on Monday, citing comments last week from European Central Bank President Jean-Claude Trichet indicating policy makers may raise interest rates as early as next month. Barclays expects the shared currency will rise to $1.45 in a year's time, up from a previous forecast that it would reach $1.42. But in the next one to three months, it will slide back to $1.38 due to peripheral-debt problems and bank stress tests, strategist Paul Robinson wrote in a note.
What took so long if all Barclays did was examine Trichet's statement?
If one is looking to enter the game, direct exposure to the Euro and Dollar can be obtained through the ETFs Euro Shares ETF (FXE) and the PowerShares Dollar Bullish (UUP). A position would depend on the believability of the ECB’s true motive behind its words — and there has been no action thus far. The next ECB meeting is on April 7, 2011.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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