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March 22, 2006

Dollar Wakes as Big Ben Rings
by Ashraf Laidi

Fed Chairman Bernanke's speech this evening was not one from which the market was ready to glean the Chairman's assessment on the state of the US economy as it was scheduled 1 week before the FOMC decision. Instead, the Fed Chairman stuck to explaining the cause of the generally low levels of long-term interest rates and of the flat and recently inverted shape of the yield curve. Bernanke sounded off the oft-mentioned reasons for low long term rates, namely: stable inflation; pension funds' demand for long-term securities in light of demographic changes; increased demand for US Treasuries relative to the issuance of new supply and; to a lesser extent foreign accumulation of dollar reserves.

He also said rising demand for long term securities was due to falling risk premium, which is more likely to be the result of falling interest rate risk than falling inflation risk.

Bernanke challenged the notion that inverted yield curves signaled a significant economic slowing as was in the past episodes because current interest rates "are relatively low by historical standards".

More importantly, Bernanke tied in his assessment of falling rates to monetary policy and adopts an if-then analysis stating that short term rates would have to be higher in the event that long-term rates reflect a declining risk premium because that would imply stimulative economic conditions. On the other hand, short term rates would have to be lower in the event that long term rates reflect macroeconomic conditions -- such as investors' projections of future economic weakness.

It seems that the Fed has largely espoused the former view, namely, falling yields being a reflection of low risk premium resulting, which suggest the rise in short term rates.

Rather than indicating his assessment for current and future economic/market conditions, Bernanke stuck to explaining the possible reasons for the current economic/market conditions.

Interpretation

The fact that Bernanke opted out from describing the current state of the economy and concluded that central bankers ought to be like navigators: "First, determine your position frequently. Second, use as many guides or landmarks as are available" suggests that that May 10th FOMC meeting is too far away down the horizon for the Fed navigators to make a single decision on its position, and that the 7 1/2-week period will offer a considerable amount of economic guides and landmarks by which the Fed will need to steer its ship.

Some may characterize Bernanke's speech as upbeat as he stuck with the view that the inverting yield curve did not suggest an economic slowing. But it is unexpected from the head of the US central bank to foresee an economic slowdown in the midst of a tightening cycle since it would risk triggering an excessive decline in short term market rates and potentially undoing the back-up in long tem yields that was effective in bringing about the much sought cooling in the housing market.

Bernanke refrained form categorical praise of the US economy and the use of such qualifiers such as "performed impressively", "sustained expansion"; "gained traction" or "advance briskly".

Bond - FX Market Reaction

The yield curve remained flat throughout the speech as the yields on both 2 and 10 year notes remained largely at 4.66% (see chart below). The dollar edged up against the euro (see chart below) and the yen, with the gains mainly held against the European currencies as Bernanke's opting out of monetary policy assessment meant an espousal of the status quo, namely, the possibility for a May tightening to 5.00%.

We could see the dollar drag down the euro further towards $1.21 as part of the usual pre-FOMC dollar strength and persistent unwinding of the euro longs. Any EUR decline below the $1.21 figure is seen encountering strong support atop $1.2050 for a renewed bounce towards $1.2150, which is our month end EURUSD forecast -- published on March 6.

Ashraf Laidi
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