Central Banks Need To Keep Their Nerve

Financial markets may be close to panic, but central bankers are still keeping their nerve.

If anything, monetary officials could be managing just the adjustment in global risk they have been wanting for some time. Risk appetite will have been reduced without triggering a wholesale sell-off. Carry trades will have been unwound without the yen rising too violently. And many of the unregulated hedge funds that have been sailing close to the wind will have been put out of business without inflicting damage on the world's major financial systems. If monetary officials can achieve this without serious damage on the global economy, central bankers from U.S. Federal Reserve Chairman Ben Bernanke down will be smiling. The froth will have been blown off the top of financial markets and risk of some explosive crisis will have been removed. St. Louis Fed President William Poole more or less spelt this out in his comments late Wednesday when he said "it's premature to say that this upset in the market is changing the course of the economy in any fundamental way. "The issue for me is whether it's going to spread into business fixed investment and the consumer segment more broadly. I don't see evidence that this is taking place," he said. The problem is that financial markets still aren't convinced. Instead of assuming that the regular injections of money-market liquidity by central banks across the globe will ease lending conditions and prevent a serious credit crunch, they are still looking for Armageddon - with the Fed being forced to cut interest rates and prevent a global meltdown. "Despite Poole's commentary, the market is still pricing in some Fed response sooner rather than later and appetite for the global rate hiking cycle has all but disappeared," said Dustin Reid, senior currency strategist with ABN AMRO in London. By Thursday, risk aversion had soared again to levels above those seen after the LTCM crisis in 1998 and the Sept. 11 terrorist attacks in the U.S. in 2001. Treasury yields also plunged, with U.S. Fed funds futures now discounting the possibility of a rate cut either before or at the next policy meeting Sept. 18. In the U.S., the S&P 500 index has essentially wiped out all the gains it has made over the last year, and on the foreign exchanges the dollar may be benefiting from a general flight to safety, but its has fallen about 4% against the yen in the last four weeks as carry trades have steadily unwound.

Weak Signs That Central Banks Are Perturbed

Nevertheless, there is little sign of central bankers losing their nerve. Henrik Gullberg, a currency strategist with Calyon Credit Agricole in London, noted that recent data from the U.S. has been strong. "The probability is that the preliminary U.S. second-quarter GDP growth will be revised up significantly, and (earlier this week) saw solid U.S. price and activity data for the beginning of the third quarter, so one could argue that the current (downward) momentum in dollar/yen is stretched at present," Gullberg said. Sure, the Bank of Japan and the Reserve Bank of Australia found themselves back in the market Thursday and Friday injecting fresh liquidity even though they had been able to drain some earlier in the week. But the central bankers have been anxious to relay a message of "business as usual" and that monetary policy per se remains on course. When given an opportunity to comment on the yen's sharp rally the Japanese vice minister for international affairs Naoyuki Shinohara failed to give any impression that the authorities are about to intervene to stop it. "It largely remains that central banks are pretending that the financial market re-pricing seen so far is largely benign and will have little significant effect on the real economy," said Bernard Connolly, a senior analyst with Banque AIG in London. Wednesday, Norges Bank did just that by hiking its rates by 25 basis points to 4.75%, and some economists reckon that the European Central Bank could send an even more significant signal to the markets by following suit at its policy meeting early next month. Jonathan Loynes, chief European economist with Capital Economics in London, said the Norges Bank move "supports our view that central banks are unlikely to be deflected from their planned policy paths by the recent developments in financial markets." "We expect the ECB to follow suit by raising interest rates again next month," he added. The Japanese are also proving just as forthright. Although many in the market have been suggesting that the Bank of Japan is now unlikely to hike its rates from 0.50% next week, Prime Minister Shinzo Abe has stepped in, stating that he expects the Bank of Japan to make an appropriate decision on monetary rates, taking economic conditions into account. Early Friday, market pressures remained, with the dollar sinking to Y112.11 by 0725 GMT from Y113.03 late Thursday in New York, according to EBS. The euro was also down sharply at Y150.22 from Y151.54 and down at $1.3397 from $1.3410.