Greenspan's Monetary Policy Testimony - February 2004

By Scott B. MacDonald

Greenspan's semi-annual monetary policy report on Wednesday (February 11, 2004 to the House Financial Services Committee) has clearcut implications for currency markets and the corporate bond market. If Chairman Greenspan takes a dovish (less fearful of inflation) approach we would expect that the market pushes EUR-USD through its recent highs (to 130), and ultimately lead to ECB intervention and/or lower rates. The European central Bank has not intervened in the foreign exchange market by buying or selling Euros since 2000, when it purchased its own currency. A dovish Greenspan would also renew downward pressures on USD-JPY and USD-Other Asia. A hawkish Chairman would let the ECB off the hook and possibly lead to a short-covering dollar rally in Asia before favorable reflation dynamics re-assert themselves. Obviously if the dovish testimony is given with the hint that interest rates will remain low for a long time, the U.S. corporate bond market should find this good news.

Greenspan's testimony is important as it comes directly after the G-7 meeting in Boca Raton. During that meeting officials collectively agreed that the rise of the Euro over the past six months has been too fast and that there was aneed for "more flexibility" in exchange rates. There was an important consensus that any further dollar depreciation should be at a slower pace and it is essential to keep the pace orderly. Markets took the G-7 stance as an indication that officials are not dissatisfied by the level of current exchange rates but will have little tolerance for sharp moves going forward. As one forex publication noted: "This sets the stage for a collision between FX markets and officials. Greenspan's semi-annual monetary policy report will determine how quickly that collision course is met."

Greenspan's testimony may be a more accurate reflection of the U.S. stance. A dovish testimony would point to the possibility for a long period of low interest rates, and open the door for the next leg down in the dollar. We will quickly learn whether the G7 are serious about imposing a speed limit on euro gains. The ECB would actually have to move past the talking phase to an action phase (buying Euros). We think that there is a very good chance that under this scenario the Euro could move rapidly to the 130 range, which will test the ECB's resolve and confidence.

A hawkish testimony moves us in the entire opposite direction: the scope for earlier rate hikes in the US, coupled with the G-7, could mark the beginning of a significant trading correction higher in the dollar. If the G-7 meeting was really about an ongoing, yet orderly depreciation of the dollar, then we could well see a more hawkish stance from Greenspan. This would be a relief for the Europeans and Japanese. However, if Greenspan wants to play to domestic U.S. markets, the dovish approach of a long period of low interest rates will be taken. The Fed is placed in an interesting position: it has little desire to be seen as a force that could prematurely kill off the U.S. economic recovery, especially considering that there is a nagging sense of apprehension over the lagging employment picture. Consequently, we expect a dovish testimony.

It would appear that the Japanese government also expects a dovish testimony> - the Diet very recently made Yen 21 trillion ($198.6 billion) available to the Ministry of Finance for yen sales. That sum compares with the more than Yen 20.4 trillion Japan sold last year and is about a quarter of the Asia Pacfiic country's foreign exchange reserves. Equally important, Finance Minister Sadakazu Tanigaki stated on Saturday that the call for "more flexibility" in exchange rates was not aimed at Japan, hinting that G-7 countries would not oppose his country's efforts to stem the Yen's 1> 3% rally in the past six months. We expect that Japan will be very aggressive in defending the Yen at the 105 mark to the dollar - at least until March 31, the end of the fiscal year.

For the corporate bond market, the implications are that the Fed will not be moving on interest rates any time soon. Although this could change (depending on U.S. economic data), that would take the apprehension about interest rates off the table for at least the next few months. This is potentially positive on two fronts: the idea of ongoing low rates could help unlock the new issue pipeline (which has been at a trickle-like pace) and it reduces the risk of interest rate volatility (which is a factor for the higher beta names such as autos and Emerging Markets). If so, a dovish Greenspan testimony could be good for the corporate bond market, helping to reduce some of the uncertainty, pushing spreads tighter. A hawkish response would imply rate hikes somewhere in the short-term, which would certainly have a negative impact on higher beta names.

 
Scott B. MacDonald is a Senior Consultant at KWR International, Inc. KWR International is a consulting firm specializing in the delivery of research, public/investor relations and advisory services.

©2004 KWR International