While the Bank of Japan’s meeting this week is virtually guaranteed to show a steady hand at 0.50%, we’ve seen the Japanese yen gain some ground as risk aversion grows in the market – signaling that a rate hike isn’t necessarily needed to unwind carry trades.

BOJ – Can The Carry Come Undone Despite Low Rates?
ECB – Paying Lip Service
BOE – Is 5.75% Enough? Not Likely.

Yield Spread Analysis 07/03 – 07/10

Throughout last week, we saw yields pick up across the board amidst strong fundamentals and hawkish rhetoric from multiple central banks. However, this Tuesday wrought very different price action as risk aversion inundated the markets, sending yields plummeting and limiting some of the strong moves we saw in many yield curves. The bout of risk aversion came as the S&P announced that they may cut ratings on $12 billion of subprime mortgage-backed bonds. Meanwhile, short-term Canadian bond yields eased back after the Bank of Canada hiked rates to 4.50 percent, but issued a less hawkish-than-expected policy statement. While they left the door open for another round of policy tightening, noted concerns about the strength of the Canadian dollar signaled that any interest rate adjustments will not occur in the near-term.

Looking ahead, the Bank of Japan meets on Thursday. Unsurprisingly, markets are not expecting any rate normalization by the central bank given the persistence of deflation in the economy. Furthermore, government officials have not been shy to state their discomfort with recent talk about a rate hike in August once the LDP elections are over.



BOJ – Can The Carry Come Undone Despite Low Rates?

While the Bank of Japan’s meeting this week is virtually guaranteed to show a steady hand at 0.50%, we’ve seen the Japanese yen gain some ground as risk aversion grows in the market – signaling that a rate hike isn’t necessarily needed to unwind carry trades.

Meanwhile, central bankers remain optimistic that prices are will become more stable, opening the door to rate normalization talks:

Toshihiko Fukui, Bank of Japan Governor

“The year-on-year rise in core consumer prices, which excludes prices of fresh food but includes energy prices, could stay around zero in the short run. From a longer-term perspective, consumer prices are projected to follow a positive trend (upwards), as the gap in production continues to improve. The Bank of Japan will closely watch developments in the economy and prices and manage monetary policy appropriately, with a view to achieving sustained growth under stable prices.” – July 6, 2007

“We will contribute to realizing sustainable growth under stable prices…As for the outlook, sustainable growth will likely continue under a favorable cycle of production, income and spending.” – July 6, 2007

Toshiro Muto, Bank of Japan Deputy Governor

“As stated in the (bank's) outlook report (released in April), the BoJ will gradually adjust rates in tandem with the pace of an improvement in the economy and prices, and after confirming the likelihood that sustainable economic growth will continue under stable price conditions.” – July 3, 2007

However, government officials are quick to state that the completion of the LDP elections in July will not yield a rate hike in August:

Kozo Yamamoto, Japanese Senior Vice Minister of Economy, Trade and Industry

“The BoJ appears to be generating an atmosphere that the next rate hike will come in August, but it should help put an end to deflation first before even considering a further rate hike.” – July 5, 2007

Shigeyuki Goto, Head of the Liberal Democratic Party's Monetary Policy Panel

“Under present conditions, an August rate hike cannot be accepted…It has been only five months (since the BOJ last raised rates). As for the speed (of rate hikes), the BOJ should be cautious and fully examine potential economic risks before actually raising them.” – July 9, 2007

ECB – Paying Lip Service

Members of the ECB remain hawkish and still see room for monetary policy tightening. However, the lack of the use of the term “vigilance” regarding inflation makes it clear that a rate hike is not in the cards in the near term, and may not be a serious issue until September:

Jean-Claude Trichet, European Central Bank President

“Looking ahead, acting in a firm and timely manner to ensure price stability in the medium term remains warranted. The Governing Council will continue to monitor closely all developments to ensure that risks to price stability over the medium term do not materialize and medium to longer-term inflation expectations in the euro area remain solidly anchored at levels consistent with price stability.” – July 5, 2007

“There is very, very strong support in Europe for our price mandate and for our independence.” – July 4, 2007

Jose Manuel Gonzalez-Paramo, European Central Bank Executive Board Member

“No one doubts the strength of growth today is significantly higher than what we expected a year ago, so that requires us to monitor a bit more intensely because of the strength and extent of growth.” – July 5, 2007


Axel Weber, European Central Bank Governing Council Member

“In the medium and long term there is still a statistic connection between the development of liquidity and prices.” – July 3, 2007

BOE – Is 5.75% Enough? Not Likely.

Now that the BOE has hiked and continued to reflect a hawkish bias, price pressures remain the primary concern as tighter policy may be necessary. The central bank had expected wages to be a major driver of inflation, but they have proven to hold steady. Does this mean the BOE will move to a more neutral stance, or do they see other risks to price stability?

John Gieve, Bank of England Monetary Policy Committee Member

“The issue for me is have we done enough to bring inflation back on a sustained level of two percent in the long term. We have seen inflation well above target for most of the last year. It is now coming back quite sharply as gas price increases of last year fall out and we get some gas price decreases…There are some signs that the past interest rates may be coming through in consumption and housing, but it is not clear cut yet.” – July 10, 2007

David Blanchflower, Bank of England Monetary Policy Committee Member

“Wage growth has been measured…I share concerns about pricing pressures, but it's a puzzle. We've gone through the wage rounds, we know the outcome. It didn't show up in the data…The data on the demand side appears to be strong…But that hasn't translated into higher pay.” – July 9, 2007

Alistair Darling, Chancellor of the Exchequer

“What is obviously a concern to me is that when people come off a (fixed mortgage) rate that was maybe fixed two years ago, and I suspect there are a lot of people on two year mortgages, they will now come out of that, and they will then find that the rate has gone up…Our economy is far more influenced by the mortgage market than most other economies for historical reasons, and therefore getting this right, both in terms of housing supply and in terms of the financing of house purchase…is all very, very important.” – July 4, 2007

Terri Belkas is a Currency Analyst for FXCM.