Monetary policy in focus

(30.03.2011) Despite of increased attention to European debt problems, the euro has remained strong. Prospects of near term European rate hikes may explain this. We also see signs of increased attention on when the Fed will start normalizing monetary policy. As a result US interest rates rose and the dollar strengthened yesterday.

By Camilla Viland, Analyst at DNB Markets

DNB markets dealingroomEuropean debt problems do again attract a lot of attention in the markets. Uncertainty regarding Portugal and whether the country will have to receive a bail out to deal with its debt burden has in particular been in focus. When turmoil hit Greece last spring and Ireland towards the end of last year, the euro weakened significantly.

This does not seem to be the case this time around and the euro remains strong. One reason for this may be that the markets already have discounted a possible Portuguese bail out. Furthermore worries regarding contagion to larger and more important countries, like Spain, do also seem to have abated. This again has reduced the risk of a total euro collapse. Furthermore European leaders seem to be more united and they show larger willingness and ability to solve the issues the region is facing, which is positive for the euro.

The main reason why the euro remain strong do however seem to be due to expectations of interest rate hikes from the European central bank. At their latest interest rate meeting ECB signalled that a first hike was nearing. The market currently seems to price in interest rate hikes from the ECB totalling more than 90 basis points before year end. In our view this seems too aggressive. Fiscal tightening is expected to weigh on growth going forward. Thus, we do not believe the ECB will have room to hike rates more than 50 basis points this year. We do accordingly believe both that European growth will disappoint and that interest rate expectations will abate. If, so the euro should weaken.

We also do see tentative sign of increased attention on US interest rates. On Friday Fed's Charles Plosser held a speech where he said a normalisation of monetary policy would have to start in a "not too distant future". Plosser is known as a hawk and his views alone should not be given too much attention. Yesterday James Bullard from St Louis Fed followed Plosser advocating that policymakers cannot wait until all uncertainty is gone before starting to normalize monetary policy.

The comments made over the last few days have gained a lot of attention. And when Fed will start hiking rates and exiting unconventional monetary policy may be a topic that will be important in the markets going forward. If so, US rates could go up and the dollars strengthen. This was just what seemed to happen yesterday. The dollar has in particular strengthened versus the yen.

Considering the latest development in key figures, it may be too optimistic to think an interest rate hike in the US is nearing. Yesterdays key figures supported this view. House prices fell for the seventh consecutive month. Thus, there are no signs of improvement in the US housing market. Furthermore, according to a survey by Conference Board, US consumer confidence fell sharply in March. The decline can probably be related to higher gasoline prices.

Today the employment figures from ADP may gain some attention. According to Reuters the private sector in the US is expected to have added 203' jobs in March. If so, this will be another sign that the labour market is slowly, but gradually improving. The ADP figures are often used as an indication of the outcome of the important US payrolls figures which are due on Friday.