Talk From The Trenches: Changing Face Of Central Bank Policy

By Bill Sokolis, Michael Chrysostomou, Nihit Joshi

     CHICAGO (MNI) - Central bank monetary policy drew a lot of attention this

week with the Bank of England raising rates for the first time since July 2007

Thursday while the US Federal Reserve holding rates steady Wednesday.

     Though the announcement from the Federal Reserve was not that exciting, US

President Trumps announcement of current Federal Reserve board governor Jerome

Powell as the next Fed chair that kept markets rapt.

     Meanwhile, a warm welcome for Nihit Joshi and his Europe addition on

peripheral bond activity. 

     US:

     Taylor puts vs. Powell Calls? Monetary vs. fiscal policy.

     US President Trump finally announced his pick of the next Fed chairman

Thursday, current Federal Reserve board governor Jerome Powell. Powell, who

still needs Senate confirmation, is deemed a centrist/dove and is unlikely to

shake up markets as he carries on Janet Yellen's legacy.

     In the weeks leading up to Thursday's announcement, rates reacted

negatively to any talk of Stanford economist John Taylor (as well as former Fed

board governor Kevin Warsh when he was still in the running), as their more

hawkish policy views would have spelled a faster policy normalization.

     As a result, option traders buying massive amounts of low delta puts deemed

"Taylor put" that covered a broad swath of the Eurodollar futures curve

(December 2017 through 2020) to hedge rate hikes not priced into the curve.

     With Powell likely to be confirmed on February 4, 2018, should long put

position holders liquidate and buy "Powell calls"? Perhaps.

     Forget about balance sheet reduction for the moment, potential changes to

the underlying make-up of monetary and fiscal policy makes for a lot of

uncertainty.

     The Australian Financial Review reported Thursday that US President Trump

has the "potential to appoint up to five new members on the 12-member FOMC, the

most in any 12-month period in at least 60 years" that includes "Powell as

chair, a vice chair to replace the retired Stan Fischer and the recently

appointed governor Randal Quarles who oversees financial supervision."

     NatWest Markets economists note that "Powell does not appear to have strong

views on monetary policy" and "may be heavily influenced by his supporting cast.

Thus, Trump's selections for the remaining open seats on the Fed could influence

market expectations for future policy."

     "Trump will be under pressure from conservative Republicans to appoint more

hawkish policymakers critical of the Fed's ultra-low interest rates and $US4.5

trillion asset purchases," AFR reported.

     Tighter monetary policy meet looser fiscal policy.

     A long awaited tax reform bill was also announced Thursday with massive

cuts of $1.5 trillion over a decade. If the bill passes, the massive boost to

the economy is likely to spell higher rates at a faster pace than currently

inscribed on the Fed boiler-plate.

     Maybe keep the downside insurance and call them "Powell puts" instead.

UK:

     The Bank of England gave what the market was pricing and duly raised

interest rates by 25bps to 0.50% Thursday with a 7-2 vote as Ramsden and

Cunliffe dissented, however, at the same time removed the sentence that Bank

Rate may need to rise rates more than the market expects, and added that further

rates hikes will be "at a gradual pace and to a limited extent" and therefore

gave a dovish tone to the minutes. Gilts rallied and Sterling fell sharply as

markets pared back chance of rates raising for a second time within the next

12-months.

     Lloyds Bank said the "updated inflation profile is conditioned on two

further rate hikes over the next three years. This, on the face of it, would

suggest that the Bank may need to raise rates by more than the markets are

currently expecting. However, the absence of such a statement on this occasion

delivered a more dovish outcome to today's meeting than was expected".

     Lloyds goes on to say that if weak productivity and subdued business

investment continues and slack diminishes in the labour market, this would

suggest any increase in economic activity is likely to lag behind demand and as

a result, Lloyds expect BoE to raise rates gain in Q3 2018.

     While RBC says that they now see the front end of the OIS curve as fairly

priced with a 2nd rate hike priced in for Nov 2018, but stick with their

forecast of there being no further hike in 2018.

     The sell-off in Sterling was probably less than expected as the November

Quarterly Inflation report said that rates would need to rise twice more in the

next 3-years to get inflation back to its 2% target.

     BOE also talked about how the lack of productivity in the last 10-years

matches the period seen between 1860 and 1870 and how economists have argued for

over the last 100-years why this happened and what caused the pick up in the

1880's. BOE Chief economist Ben Broadbent suggests that it was the time between

significant change in innovation/technology, going from steam to electricity.

     So maybe for the UK to get out of its stupor it will be have to wait until

we have driverless cars, more robots doing everyday jobs/tasks and a Brexit/free

trade deal with the EU to increase productivity once again. So looks like we'll

only have to wait another 10-years and for unemployment to rise as robots take

our jobs!

Europe:

     EMU Peripheral bonds - the younger siblings within the Eurozone family

continued their yield tightening spree versus German Bunds - its mighty older

brother, despite continued woes in Catalonia.

     Italy rejoiced in some good news last Friday following S&P's upgrade of its

sovereign credit rating from BBB- to BBB, with a stable outlook.

     Also helping Italian BTPs is that the European Central Bank continues to

take a softer approach towards tapering of its quantitative easing programme,

opening up an opportunity for peripheral bond prices to stay bid in the near

future.

     Italian borrowing costs on the 10-year part of the curve have dropped to

their lowest since early January and the spread between the German Bunds

continues to tighten and last at +143bps.

     Portuguese bonds have long been the black sheep of the family with a status

below investment grade assigned by two of the three major ratings agencies.

However, it is widely anticipated that the Portuguese bond rating will soon be

upgraded. Similar to the story in Italy, the borrowing costs for Portugal's

10-year bonds have also decreased significantly and the spread with the German

Bund has also tightened to +171bps - levels not seen since May 2015.

     The attention seeker in the Eurozone family continues to Spain! After an

extended time period of bitter internal disputes, the Catalonian independence

bid appears to have been put on hold momentarily after the Spanish government

invoked Article 155 last Friday.

     That said, Spain continues to underperform its Eurozone peripheral siblings

- in particular Italy, where the 10-year BTP/SPGB yield spread has now tightened

to +32bps from around +54bps in mid-October.

     Looking ahead into next week, Catalonia will continue to grab headlines

with focus on civil protests and ability of the Spanish government to take

control ahead of the regional elections on Dec 21. Markets will also eye the

Eurogroup meeting on Monday, EcoFin on Tuesday, ECB Economic Bulletin and EU

Commission forecasts on Wednesday.

     Talk From the Trenches is a compendium of chatter from trading rooms, and

is offered as a gauge of the mood in the financial markets. It is not

necessarily hard, verified news.

--MNI Chicago Bureau; tel: +1 312-431-0089; email: bill.sokolis@marketnews.com