The Dangerous Dance of Central Banks

These must be exciting times to be a central banker, what with their usual heavy schedule of causing confusion to elected officials and of hurling verbal thunderbolts into the cowering citizenry simultaneously, the Masters of Money are starting to find themselves out of sync with each other.

How will those divergent courses affect global investors? Let's just say there's reason for concern, especially in Japan and the U.S.

European Sophistication?

Consider first the European Central Bank, caretaker of the euro. Early in everyone's elementary education we are assigned to work on a project as part of a committee. Here we learn that committees are excellent accomplishment-prevention devices, and the products of committee labor often address internal politics far better than they do external realities.

The ECB has been embarrassed by the euro's nearly continuous fall against other major currencies since its inception. Much of the weakness against the U.S. dollar could be explained away by the Fed's series of interest-rate hikes, culminating in May's 50 basis-point increase, but the weakness against currencies such as the British pound or Japanese yen would be harder to explain. Well after the euro bottomed on May 18, the ECB raised its rate 50 basis points on June 8 -- and then announced it did not expect to have to raise rates further.

The ECB had not hinted at any rate hikes going into June 8. The problems of European inflation were not apparent on their face. European equities markets were modestly higher on the year, just 3.41% for the Bloomberg European 500 index and 9.15% for the Dow Jones 50 Stoxx index, hardly the stuff of a runaway bull market. In light of all this, the ECB's decision is a triumph, accidental or otherwise, of the committee process. As a plus, American investors in European stocks are likely to benefit from a stronger euro.

Relative Value of Euro Vs. Other Currencies

Source:Bloomberg

Land of the Rising Sun and Falling Stocks

The Bank of Japan has been trying, with no success whatsoever, to jump-start Japan's moribund economy through near-zero interest rates for the better part of the past 10 years. Some have argued the bank's policies actually have been constrictive during this period. With price deflation rampant in Japan, a nominal interest rate near zero is a real interest rate equivalent to the rate of deflation, currently 1.7% as measured by the gross domestic product deflator.

What, then, does the Japanese bank propose? Raise interest rates, of course! Its logic is based on the notion that free money has allowed Japan Inc. to conduct business as usual and avoid recognizing the structural problems of its political and economic system. While we can debate the wisdom of raising real interest rates in an economy with one of the highest levels of public debt in the world, the performance of the benchmark Nikkei 225 index during this period speaks for itself, as seen below.

Nikkei 225 Vs. Japanese Rate Expectations

Source:Bloomberg

Once the Bank of Japan hinted an end to the zero-rate policy in mid-April, the Nikkei peaked and began a selloff that has pushed the index down 21.2% in two months. If the market is welcoming this apparent policy change, this is certainly an odd way of showing it.

The Fed: A Hike Too Far?

Monetary policy operates with long and variable lags, which is a fancy way of saying we don't know what's going to happen or when, but we're going to do it anyway. U.S. economic data reported over the past month have been uniformly softer than expected, and this may be incorporating only the effects of the first 50-75 basis-point increase in rates from 1999. More softness may be in the pipeline and would manifest itself even if the Fed were to cut rates tomorrow.

The U.S. interest-rate market is starting to price a rate cut into its forward structure. In mid-May, the market was expecting to see at least another 25 basis-point hike in rates by the first quarter of 2001. This expectation has turned into a decline of five basis points over the same period, as seen in the graph below. It can be seen on a quick-and-dirty basis by noting the price of December 2000 Eurodollar futures is less -- and therefore the yield is higher -- than for March 2001 futures.

The Divergence Decade Continues

This is some spectacle: The U.S. economy, which has been the strongest in the world, is slowing so rapidly the market is now expecting rate decreases. Japan, which has been the weakest major economy for years, is expecting interest increases, and these expectations are hammering the Nikkei once again. Europe is in the middle in both growth and rate expectations.

The Fed, like most traders, hates to admit error and take small losses, so it may be reluctant to reduce interest rates just yet. While the betting here is against an outright recession, we'll probably have to settle for slow growth at best for a while.

The Japanese are taking a big risk in their impending policy reversal for both themselves and the world at large: Much of the late 1990s financial boom worldwide was financed with cheap yen. Europe may be the best alternative by default, and an American investor might be in line to gain on both the underlying asset and on a strengthening euro.

Relative Equity Performance as a Function of EUR Performance

Source:Bloomberg

Since the euro's January 1999 inception, European stocks as measured by the Financial Times Euro 300 index have outperformed the S&P 500 index in euro terms, but have underperformed for U.S. investors in dollar terms. A strengthening euro makes European stocks more attractive to American investors, and that may be the best consequence, intended or otherwise, of the ECB's decision to raise rates.

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Howard L. Simons is a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of The Dynamic Option Selection System (John Wiley & Sons, 1999). Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites your feedback at [e-mail].