North America
  • The FOMC meeting this week has been the focus of a lot of attention. Earlier, three large Wall Street firms had forecast aggressive near-term rate cuts by the Federal Reserve. But Fed officials sought to dampen the speculation regarding interest rate reductions at this meeting.
  • A rate reduction now would be in contradiction with the relatively optimistic view that Greenspan, the Fed chairman, expressed just a few weeks ago in his testimony before Congress. It would heighten worries among certain investors about the state of the economy and financial markets.
  • Policymakers are likely to keep their powder dry -- noting that the fed-funds rate is already at a historically low level of 1.75% - for possible use, later, if economic conditions undergo further deterioration.
  • The equity market experienced a significant rise last week, animated principally by the expectation of interest rate cuts. There was not much cheer from the soft economic numbers and the earnings news. Wall Street was driven by the hope that the Fed would take action to sustain valuations.
  • The problem for the monetary authorities is how to acknowledge the risks in the economy without appearing either concerned or complacent. Greenspan may have said, in the past, that policymakers do not target the equity market. But this is not always the case, particularly at the present time. Wall Street is aware of this - - hence, the rally last week. However, the rally appears fragile and may be looking for reasons to continue. Right now, the market is ready to pounce on any good news that comes its way. Failing that, it is likely to loose ground.
  • Volatility will continue on both equity and fixed-income markets, as sentiment swings in favour of one or the other on rapid changes in expectations. Disappointment over no Fed move may sustain the rally in Treasuries. Meanwhile, the VIX stock-market volatility index reached higher levels. This indicates continuing investor concerns about credit conditions and uncertainty about profitability.

Europe
  • Data in the euro area indicate moderate recovery ahead, rather than a renewed slowdown. Forward-looking indicators such as the Purchasing Managers’ Index are pointing in that direction.
  • The European central Bank is on a "neutral" setting, rather than the tightening bias earlier on. It still appears to be worried about growth in money supply and price stability, despite the rise in the value of the euro. However, it is also cognisant of global developments to the downside and weak equity markets.
  • Financial markets in the euro area expect interest rates to remain unchanged, well into next year. Earlier expectations of a rise in UK rates have also been toned down, as inflation and growth signals remain muted.

Asia/Pacific
  • The Bank of Japan adopted a more cautious outlook in its August monthly report, referring to the increase in uncertainty regarding external conditions.
  • In Japan, further increases in financial instability could have negative implications for personal consumption and capital spending growth. The banking system’s bad loan problem is difficult to solve in the current deflationary environment because new bad loans are created even as past ones are disposed of.
  • Measures aimed at reversing the deflationary trend should be the focus of policymaking but it does not appear that the authorities are showing a great deal of resolve in addressing the issues.
  • The Bank of Japan continues to sell yen and buy dollars in very large amounts. However, it sterilises the move, countering a potential increase in the money supply. The Bank has been helped in its efforts to keep the yen from appreciating by foreigners, who have recently become net sellers of Japanese equities. As well, local investors increased their purchases of foreign stocks and bonds.

Bonds
  • As an indication of current market expectations, Fed-funds futures contracts are pricing in interest rate cuts before the end of the year.
  • U.S. bond managers have increased the weighted duration of their portfolios. This suggests that they are expecting a further flattening of the Treasury yield curve.
  • Conditions remain difficult in the corporate bond market, with wide yield spreads over Treasuries, as well as low liquidity. The result is that corporate borrowing is more difficult and costly. Fed action in lowering rates will not significantly improve the situation.

Currencies

  • Expectations of Fed easing have been supportive of the U.S. currency. As such hopes moderate in the near term, so will dollar strength - particularly vis-à-vis the euro.
  • With RPIX inflation forecasts now running below the 2.5% target rate, the onus is on the Bank of England to maintain easy monetary conditions to push inflation back into the target zone. This implies a negative outlook for sterling.
  • The commodity currencies (Australian, Canadian and New Zealand dollars) remain vulnerable because of evident slowdown in global growth. However, the Australian dollar recently perked up on expectations of interest rate increases.

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