Tuesday, June 10, 2008 0 comments ++[ CLICK TO COMMENT ]++

Likely Central Bank Tightening Ahead

I think central banks may be getting ready to start a tightening cycle. Ben Bernake has been extremely hawkish of late and the Bank of Canada decided today to hold overnight rates at 3%. Market consensus was for a cut so this was a surprise to many. The Globe & Mail reports:

The Bank of Canada is holding its key interest rate steady, shifting its priority away from the stagnant economy to focus instead on inflation caused by soaring commodity prices.

The central bank announced Tuesday it is putting an end to its aggressive streak of rate cuts, even though it acknowledged the economy has stagnated and could well weaken further...

Economists and market players had widely been expecting a small rate cut of a quarter of a percentage point to stimulate the economy as it deals with recessionary conditions in the United States as well as tighter credit conditions.

Economists had also said that the central bank could quite easily justify a more aggressive rate cut to confront a slowdown in Canada, or swing the other way and freeze rates in the face of rising commodity prices. But they hadn't picked up any hints from the bank that anything other than a small rate cut was in store, and they assumed the central bank under Mr. Carney would continue the pattern set by his predecessors of preparing markets for a change in direction.

GDP actually contracted in Canada in the first quarter, whereas it is still positive in the US, so some had been expecting further cuts. There is another story in the Globe & Mail which mentions that Canada, which had been cruising on the commodity boom, is starting to feel the negative side-effects of slowdown. Unlike many other "commodity countries", Canada is a "weird" one in that most of the economy is still manufacturing or services, and heavily dependent on the US. The market--at least the stock market--perceives Canada as a commodity nation but it is only partly true. Of the developed countries, other so-called commodity countries such as Australia and Norway are more of a pure commodity countries.

Clearly, inflation is being taken a bit more seriously by some central bankers. The really big inflation problems are still in developing countries, many of whom have negative real rates. Unfortunately, due to a whole hoard of reasons (mostly political,) these countries are still pursuing an inflationary policy.

As for the central bank that really counts, the Federal Reserve may start hiking later in the year. The probability of a rate hike in August, according to the Fed Funds futures market, has been steadily rising lately:

(source: Federal Reserve Bank of Cleveland)

The futures market are very flaky and are often wrong, except close to expiry. Just like how the oil futures had been wrong for several years, the fed funds futures oftens switches abruptly and approaches the correct value as we close in on the FedRes meeting.

What does this mean for investors? I think it is possible for asset prices, including commodities, to decline. If you are a bottom-up value investor or a contrarian looking at beaten-down stocks, none of this probably means anything. If anything, assets may get cheaper but one cannot be certain.

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