Busch: Fed Shirts vs. Skins

United States Federal Reserve
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United States Federal Reserve

There appears to be a jump ball for the direction of the Federal Reserve and monetary policy as FOMC voting and non-voting members spoke last week. It will continue this week as we have several speakers including Chairman Ben Bernanke ready to take a shot and score points for their view. An intriguing game of Dove shirts (Dudley) vs Hawk skins (Fisher) is playing out.

It’s interesting to see the recent commentary has shifted from caution and keeping the full QE2 to what instruments should the Fed use when it decides to reverse its easy money policy. While no one anticipates an early exit to QE2 before it ends in June, the economic data will drive expectations as growth in jobs accelerates as well as inflation. This is critical for the direction of the currency markets.

Currently, the major driver of value in foreign exchange is interest rate differentials. This is how the euro currency can rally over the last two months despite the generally negative news on Greece, Portugal and Ireland. This is highlighted by the fact that periphery bond yield spreads to German debt continue to expand and reflect the nervousness of bond investors. The expectations are for the ECB to raise interest rates on Thursday by 25 basis points and will potentially exacerbate the tenuous economic conditions in the PIIGS.

The markets began to react to commentary on rate hikes by the ECB at the end of January and have now moved the 1 year euro overnight index average, a measure of interbank loan rates, about 75 basis points since. The easiest spread to look at is the German-US 2 year note spread. This was at 55 basis points in January and moved to 112 points in March. It’s now 105 points and very supportive of the euro currency.

The ECB is the first major developed country to signal they will begin to raise rates and will likely act on Thursday. This doesn’t mean it’s the correct course of action and the ECB has made serious policy mistakes in the recent past by raising rates too early. (Remember, the ECB raised rates by 25 basis points in July of 2008.) The point is that they are going to raise rates, spreads have moved and the euro currency has rallied.

If the Fed shifts towards raising rates, this dynamic will change and the US dollar will begin to rally. Watch to see if any of the Fed doves (like Evans) shift take off their shirts to play for the hawks. This will be the first indication of a game change.

Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a contributor to CNBC's Money in Motion Currency Trading.You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.

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