Three central banks, three problems

Well....whoever was at 1490 in the SPX must have gone out to lunch at an inopportune time yesterday, because the level finally broke and generated a pretty aggressive follow-through. The chart suddenly looks pretty ugly, and with little near-term prospect of monetary relief this market may decide to have a proper go at the downside. This may ultimately provide the opportunity to scoop up some handsome bargains, but the for the time being Macro Man is content to stand aside and let his hedges do their work.

Today sees news from three different central banks, all of whom find themselves in a different situation confronting different problems. How they choose to address these issues may ultimately tells us quite a bit about the resepctive institutions.

First off is the Bank of England, which announces its rate decision at noon local time today. While a few are looking for a 25 bp cut, recent hawkish comments from a number of MPC members make this a highly unlikely outcome, in Macro Man's view. A more pressing issue for the Bank is its stature, its reputation, and even its very independence from government meddling, which is being called into question for the first time since Gordon Brown freed the Bank in 1997.

Over the past week markets have subjected to the rather unedifying spectacle of a pissing match between Chancellor Alistair Darling and BOE Governor Mervyn King over who should carry the can for the Northern Rock debacle. The arguments, summarized in the graphic below, at least raise the possibility that the Bank delays any required monetary easing to avoid the impression of caving in or supporting the Government's wishes.
Forty-five minutes after the BOE, the European Central Bank will also announce its rate decision, followed by a press conference at 1.30 pm London time. It is the latter event which will be the primary object of focus, as the market scrutinizes M. Trichet's comments for signs that the tightening cycle is over and/or that the euro has become a source of concern.

It is incontrevertible that the euro has led to a tightening of monetary conditions; indeed, the EUR's real effective exchange rate, combined with real interest rates in the Eurozone, have generated the tightest monetary conditions in Europe since 1992. While this comes in the context of higher-than-target inflation, it also seems clear that the level of the currency is beginning to have a material impact on corporate profits and, by extension, growth.

EADS announced Q3 "earnings" today, wherein they reported a loss of "only" €776 million, better than the expected €1.15 billion loss. But the insight on currency hedging is instructive; through the first 9 months of the year, EADS saw $11.8 billion worth of hedges mature: the average rate was 1.14 EUR/USD. In their stead, EADS has placed fresh hedges totally $15.1 billion, with an average rate of 1.37. That is a material change in competitiveness that is no doubt being mirrored elsewhere in Europe (or at least France); why else would Nicolas Sarkozy warn the US Congress that dollar weakness could lead to "economic war"?

Speaking of the US Congress, the Joint Economic Committee welcomes Ben Bernanke to the dance floor today for testimony on the US economic outlook. We can expect him to be peppered with queries on subprime, housing, and the banking system, and perhaps also the level of the dollar. Yesterday's barrage of Fed speakers made it pretty clear that they are comfortable with where rates are as things currently stand, though we should probably expect BB to note that the Fed stands ready to act should conditions deteriorate markedly from here.

What's interesting is that several of yesterday's speakers also mentioned the level of the dollar, a topic that has been absent from their comments for the past several years. Could we perhaps be morphing towards a May 2006 scenario, wherein the Fed belatedly realizes that they are suffering from a credibility deficit and decides to "talk tough" to restore the balance, even in the face of crumbling risky asset prices?

Certainly the dollar's sell-off has been accompanied by a sharp rise in breakevens and, of course, commodity prices; this has clearly not gone un-noticed. And while 10 year breakevens are not at particularly pernicious levels, a further deteriorarion may, in the Fed's mind, warrant greater concern.

This is exactly the sort of concern that Macro Man raised yesterday- namely, that the potential inflationary consquences of a free-falling dollar force the Fed to maintain its monetary course even in the face of tumbling equities. In May 2006, such tough talk eventually spurred a sharp correction in stocks, emerging markets, and even (albeit temporarily) the dollar.

All the more reason, then, to watch today's developments clsoely; Macro Man dearly wishes to avoid seeing central bank problems become his problem.