Central bank watch

After the ECB eased policy via rate reductions and the introduction of asset purchase programs, the attention is now shifting to the Fed and BoE and when the might start making policy less accommodative.

The Federal Reserve continues to play a steady hand in terms of managing expectations, with its commentary and forecasts not deviating a huge amount in the last 3-4 months.

Growth forecasts have been revised downwards thanks to an increasingly weak Q1, while private sector forecasters are revising Q2 lower as the post-winter bounce hasn't proved to be as strong as initially hoped.

This weakness, however, hasn't derailed employment growth, which has proven to be stronger than expected in the last 6 months.  We have also seen an uptick in actual and expected inflation closer to 2%.

The stronger employment and inflation data have tended to embolden expectations for a rate hike from the Fed in 2Q15.  It has also had an interesting impact on the yield curve, with the short end of the curve rising, but the longer end remaining very well bid.

It's interesting that the 2-5 year spread has remained consistent at ~125bps since the start of the year, while the 5-10 is now at its narrowest level since 2009.

There seems to be a bit of an inconsistency here. Markets are happy to sell bonds of 5 years and below on the increasing likelihood of Fed Fund rate hikes next year.  But the 10 year part of the curve remains very strong.  It would seem that sooner or later, 10 year bond yields will also rise in conjunction with the shorter end of the curve if the economy proves strong enough for the Fed to consider hiking rates.

The economic data out of the UK have continued to be on the stronger side of expectations, with employment growth in particular now strong and the unemployment rate lower than anticipated.

Market expectations appear to be much more in tune to what the Bank of England has been projecting rather than what the data has doing and this has prompted Governor Carney to state is a speech that the timing of Bank Rate hikes are data dependant and that "it could happen earlier than markets currently expect".

The Bank of England is also making more of a foray into macroprudential policy in help reduce risks from indebtedness.  The Bank has stressed that it is indebtedness, not the growth or level of a particular asset price, which is central to their concerns.  They have also stated that it is not a substitute for monetary policy and may not affect the future path of the Bank Rate. But these policies would restrain high LVR mortgage lending, as they have done in places like New Zealand.

The ECB are likely to sit on their hands for a while as they assess the impact of recent policy changes, with the TLTRO program beginning in September.

One area where they haven't gotten much traction yet is on the Euro, although it has stopped rising.  There is also a growing expectation that it will fall over time, given Europe is in a different stage of the economic cycle than other major currency areas.

This is also the view from BoJ Governor Kuroda, which has expressed satisfaction with the current settings of policy and the BoJs forecasts.  The slow-down in activity from the introduction of the VAT has been in line with expectations, with growth and inflation forecasts little changed. While energy prices will start to fall out of the inflation equation in 2H14, the BoJ expect labour market tightness and wages growth to lead to a broadening of inflation later this year.

This hasn't lead to a sense of complacency though, with Governor Kuroda suggesting they are half-way through the battle in achieving the 2% inflation target.  And until that war is won, they are likely to maintain an aggressive policy stance.