Fed Does Not Hike Discount but Greek Concerns Continue To Bolster US Dollar

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Highlights

The US dollar is firmer against most major currencies.  The euro is trading near the week’s lows while the safe haven Swiss franc is up on the day amidst ongoing concerns about Greece.  That’s despite comments from EU Commissioner Barroso that countries including Germany stood ready to give Greece aid if asked and amidst talk of a potential joint EU/IMF solution to the Greek crisis.  Dovish remarks from BoE’s Sentance who suggested that there is some risk of a double dip recession and that monetary policy can offset a fiscal tightening, weighed on the pound with the currency more than reversing the Wed/Thur gains. The Canadian dollar is sharply higher after CPI came in higher than expected at 0.4% m/m (0.3% m/m exp) while core-CPI was up 0.7% vs. 0.3% exp.

Global equity markets are mostly higher in Asia and Europe and early indications suggest US markets will open flat to firmer.  The MSCI Asia Pacific index closed up for the fourth consecutive week with export related shares gaining on hopes for ongoing strength in the US and Chinese economy.  In Japan, the Nikkei closed the day and week up 0.8% with technology shares leading the move.  The leading European bourses are up about 0.5% while the Greek Athex has recouped some of yesterday’s losses, gaining a modest 0.3%.  The index is down -4.2% on the week.

Global sovereign bonds remain mixed.  In Europe, German bonds are flat to firmer amidst the renewed concerns about Greece while the more heavily indebted European countries have seen their bonds weaken.  Greek bonds have been hardest hit.  The 2- and 10-year Greek/German spreads have widened 29 bp (vs a narrowing of -33 bp on the month) and 17 bp respectively.  UK and US 10-year yields are down 3 bp and 1 bp respectively even though Fitch warned their credit profiles had deteriorated due to the recession and financial crisis.  That follows a warning from Moody’s earlier this week that both countries are a lot closer to losing their AAA rating.  The Chilean central bank left rates on hold at 0.5% as expected. 

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Speculation swept NY on Thursday that the Fed could raise the discount rate.  We were unconvinced and sure enough no discount rate hike was delivered.  However, a discount rate hike before the end of the month cannot be ruled out.  On Feb 18th the Fed hiked the discount rate by 25 bp to 75 bp. Perhaps because it was the month anniversary some chins starting wagging, but one of the criticisms now levied against the Fed is that after allegedly leaving rates too low for too long, when it did begin raising rates it did so in a predictable fashion which did not encourage more prudent risk taking. There is not reason to have expected the Fed to celebrate the one month anniversary with another hike.  When it did raise the discount rate, the Fed–Bernanke himself–signaled it would be taking place soon and after the hike was delivered Fed officials were quick to explain that it was about liquidity management not about monetary policy.

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The same logic is still operative.  Prior to the crisis, there was a 100 bp spread between the federal funds target and the discount rate.  That spread stands at 50 bp now.  There is room then for 25-50 bp in hikes in the period ahead.  Why is a hike this month likely?  The Fed is winding down several emergency lending programs and finishing its long-term asset purchases this month.  A discount rate hike in this context would again help the market recognize this as a liquidity management tool and not a monetary policy signal.  Moreover, if the goal is to encourage banks to return to the federal funds market, then the 25 bp discount rate hike in February does not appear sufficient.  Discount window borrowings have hardly changed over the past month.  The upcoming speeches by Fed officials will be scrutinized for guidance and in particular the separation between liquidity and monetary policy. And while the Fed may be perfectly clear and correct that the discount rate hike has no bearing on monetary policy, the market knows otherwise.  That is to say that the normalization of the discount rate relative to the federal funds target is likely understood as a necessary pre-condition for an eventual rate hike.  US money market rates are already experiencing upward pressure.  The FOMC statement reiterated its concern that bank credit is continuing to contract. The Fed needs to be careful that the market does not tighten for it.  The continued normalization of US liquidity management is a prelude to the normalization of monetary policy.  It appears to be proceeding at a faster pace that the ECB, BOE and BOJ.  The discount rate hike might, it and of itself, not do much for the dollar, but what it does underscore is the direction the Fed is moving.  One of the next steps, probably in Q2, is to modify the FOMC statement’s language to allow for greater degrees of freedom.

The Canadian dollar has given up most of the week’s gains but could get some help from retail sales data today.  The January retail sales should confirm that there is still life in the consumer sector. The headline and ex-autos retail sales are expected up +0.6% and +0.5% respectively on the month (from +0.4%), highlighting a promising Q1 consumer spending outlook and confirming that domestic demand will continue to contribute to GDP growth in Q1. The low inflation environment that was highlighted in today’s CPI release supports the view that the Bank of Canada should feel in no rush to move forward the timing of the rate normalization process.  But a solid, non-inflationary growth environment is good news for the currency. We remain bullish on the Canadian dollar, with parity looking like an increasingly feasible target and selling US dollars into the rallies is still our preferred approach for the Canadian dollar.  It should also be noted that the strengthening of the Canadian dollar is an effective tightening in monetary conditions and if anything, this will weaken the case for an imminent rise in interest rates.

The Japanese yen is firmer against the crosses in European trading after a fairly quiet Asian session and ahead of the Japanese holiday Monday.  Renewed concerns about Greece have weighed sent the euro cross toward the JPY122.60 area (50% retracement of euro rally since late Feb.)  Talk of a large Japanese bank sale of sterling possibly tied to repatriation flows has contributed to sterling losses.  Today’s Japanese data had limited impact although Feb Tokyo store sales fell -6.5% y/y (from -7.4%) while, Feb nationwide dept store sales fell -5.4% y/y (from -5.7%) pointing at a likely contraction in Q1 consumer spending. Meanwhile, there was much better news from the Jan all industry activity index which jumped by 3.8% on the month, largely offsetting a 0.2% contraction previously.   

Upcoming Economic Releases                                                                       
There are no US data releases today but Canada reports Jan retail sales at 8:30 AM EDT/12:30 GMT.  The consensus expects headline retail sales to rise 0.6% m/m, up from a 0.4% pace in Dec.  Ex-autos are exp up 0.5% vs 0.4% in Dec.  The Mexican central bank is expected to leave rates unchanged at 4.5% (11AM/15:00.)  There are no scheduled Fed speakers.

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Marc Chandler is the global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

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