Investors' new challenge: Deciphering central bank 'guidance'

LONDON Thu Dec 19, 2013 12:05pm EST

U.S. Federal Reserve Chairman Ben Bernanke responds to reporters during his final planned news conference before his retirement, at the Federal Reserve Bank headquarters in Washington, December 18, 2013. REUTERS/Jonathan Ernst

U.S. Federal Reserve Chairman Ben Bernanke responds to reporters during his final planned news conference before his retirement, at the Federal Reserve Bank headquarters in Washington, December 18, 2013.

Credit: Reuters/Jonathan Ernst

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LONDON (Reuters) - The gradual withdrawal of unprecedented stimulus by the world's big central banks is officially underway, posing a new challenge to investors: how to decipher monetary policy that will increasingly amount to not much more than words.

The Federal Reserve announced on Wednesday, after months of speculation in the markets, that it would reduce the amount of cash it pumps out each month by $10 billion to $75 billion as the economy shows signs of resilience.

But at the same time it pledged to keep interest rates anchored near zero even longer than previously promised.

This forward guidance will define monetary policy in 2014 as central banks around the developed world look to withdraw the trillions of dollars of liquidity injected to prop up the global economy since the financial crisis of 2007-08.

The major central banks are at slightly different stages in the process, and forward guidance will play an important role in ensuring they progress smoothly.

The European Central Bank, which has been conducting an effective "silent taper" all year as lenders pay back cheap loans, has cut interest rates and pledged to do "whatever it takes" to support the economy.

The Bank of England, meanwhile, has promised to keep rates at record lows perhaps into 2016, but finds itself in a tight spot as the economy is now growing far more quickly than it bargained for.

If central bankers are walking a tightrope, investors are only one step behind them, hoping that the banks keep their nerve and balance.

"In the last year the big focus was tapering. The big focus now is growth and how forward guidance can help sustain that growth," said Daniel Loughney, a currency and rates portfolio manager at Alliance & Bernstein in London.

"Is this an effective tool? Can they convince the markets they can keep rates this low for longer and keep inflation down? It's very much experimental on the part of the Fed, and potentially risky if growth falters," he said.

VOLATILITY? WHAT VOLATILITY?

U.S. stock markets hit a record high on Wednesday and benchmark 10-year Treasury yields rose only slightly, suggesting investors welcomed the Fed's action as well as outgoing Chairman Ben Bernanke's guidance.

Volatility fell across the financial markets.

The VSTOXX index of implied volatility on euro zone blue-chips was on track for its biggest one-day fall since the U.S. budget deal was signed in October. The equivalent measure for Britain's FTSE 100 was on course for its biggest drop in 10 months.

Implied volatility in one-month euro/dollar options fell to 6.1 percent. Anything below 6 percent would be the lowest in over six years, showing how sanguine forex investors appear to be.

This suggests most investors don't see the Fed's reduction in liquidity as an effective tightening of policy. The bank is, after all, still pumping $75 billion into the economy every month.

By the time that program is expected to end late next year, the Fed's balance sheet will have ballooned to some $4.5 trillion from less than $1 trillion before the crisis.

Bernanke said if growth does falter, the Federal Reserve Open Market Committee could put the tapering process on hold for a couple of meetings.

But the economy may also expand faster than expected, posing an equal risk to central banks' forward guidance.

If policymakers are forced to backtrack on their interest rate pledges after only a few months, how can the market have any real faith in what they say?

"It will be a difficult communications exercise to keep the market in a 'forward guidance' framework for two years," said Ahmed Behdenna, cross asset strategist at Societe Generale in London.

The picture in Europe is slightly different. In some ways, the big two central banks are already ahead of the Fed in taking their feet off the liquidity accelerator while again strengthening their verbal intervention and forward guidance.

The BoE's bond buying program has been capped at 375 billion pounds since July last year, and despite Governor Mark Carney's pledge on rates, some in the market are betting the first hike could come in 2015 or even late next year.

Overall, the "lower for longer" interest rate environment is cautiously bullish for equities, credit markets and peripheral euro zone bonds, say Alliance & Bernstein's Loughny and SocGen's Bedhenna.

(Reporting by Jamie McGeever Additional reporting by Toni Vorobyova; Editing by Hugh Lawson)

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