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Analyst Interview: David Song on Portugal, the ECB, the Fed and ZIRP

Analyst Interview: David Song on Portugal, the ECB, the Fed and ZIRP

2012-02-07 20:00:00
David Song, Strategist
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• Do you think that a potential Greek default will cause Portugal, at present rated junk by all three of the major rating agencies, to default as well?

A Greek default would certainly rattle investor confidence, but will have little influence in pushing Portugal to default on its debt as the European Central Bank continues to shore up the financial system. The ECB’s LTRO has helped to alleviate funding costs for Portugal and conditions should improve further as the central bank prepares to launch its second unlimited three-year loan facility at the end of the month. In turn, the efforts should help Portugal to meet its debt obligations and the region should be able to tap the bond market over the medium-term as the government takes extraordinary steps to balance public finances.

• What is the chance of the ECB performing another interest rate cut by 25 bps at the upcoming meeting, such as it was hinted by Draghi? Has the situation in the Eurozone improved enough for the central bank to refrain from a cut for now?

There’s a good chance of seeing another 25bp rate cut by European Central Bank President Mario Draghi as the euro-area remains at risk of a major economic downturn in 2012. In turn, we may see the Governing Council carry its easing cycle into the second-half of the year as subdued growth dampens the outlook for inflation. As the ECB maintains it’s one and only mandate to preserve price stability; the disinflationary environment may encourage Mr. Draghi to maintain a dovish tone for monetary policy and the central bank head may weigh additional measures to shore up the ailing economy as the fundamental outlook for the region remains clouded with high uncertainty.

• Will recent, weaker than expected US economic data induce the Fed to introduce QE3 in the first quarter of 2012?

Although the Fed continues to highlight the ongoing slack within the economy, the central bank has limited scope to expand its balance sheet further as the risk of a double-dip recession subsides. As Fed officials expect to see a more robust recovery in 2012, the stickiness in the core rate of inflation could spur a growing rift within the central bank and we may see the FOMC stick to its wait-and-see approach throughout the first-half of the year as private sector activity gradually gathers pace.

• Changes in policies, such as we witnessed last week when the Fed announced that it would maintain a zero-interest policy for three years instead of just another 1-1/2 years as announced previously; do you think this announcement will be carried through, and markets will explode upwards?

In light of the recent comments from the Federal Reserve, it seems as though the central bank will preserve its zero interest rate policy throughout 2012. However, there’s been talk that we may see the FOMC start to normalize next year should the rise in economic activity fuel faster inflation. Indeed, the ‘pledge’ by the Fed is one of the key tools that the central bank has enlisted to compliment the highly accommodative policy and we should see the FOMC continue to utilize the transmission mechanism to prop up the real economy as the committee aims to encourage a stronger recovery.

• Recent COT data show record numbers in net short positions in the Euro. How much has such a positioning influenced the recent gains in EURUSD?

Indeed, the short squeeze in the EURUSD may have contributed the recent rise in the exchange rate, but the COT data should be taken with a grain of salt as it lags in nature. Nevertheless, it seems as though currency traders may have been overly bearish on the EURUSD as the Greek impasse sparked speculation for a default. However, we expect to see the single currency face additional headwinds in 2012 as the fundamental outlook for the euro-area remains bleak. Additionally, the recent appreciation in the single currency appears to be coming off on hopes that Greece will get clearance for its second bailout package, but the ‘Euro euphoria’ is likely to be short-lived as we expect the ECB to cast a weakened outlook for the region.

• Any intermarket relationship or correlation have you been following lately? Please explain.

As the Fed pledges to maintain its zero interest rate policy well into 2014, the correlation between risk sentiment and the U.S. dollar will remain intact over the medium-term. As market participants continue to treat the USD as a safe-haven, a rise in risk-taking behavior will dampen the appeal of the reserve currency, while the greenback would benefit when investors become risk-adverse. This dynamic will be an ongoing theme as long as the FOMC maintains a dovish tone for monetary policy. This relationship can be clearly seen between high-yielding currencies and global equity prices. A clear example is the AUDUSD’s relationship to the Dow Jones Industrial Average, where a 20-Day rolling correlation shows a print of 0.64. The positive correlation between the AUDUSD and the Dow gives us a good gauge on how the AUDUSD should perform when we see higher equity prices, but we expect to see the strong ties between the two asset classes break down once the Fed prepares to normalize monetary policy.

--- Answers provided by David Song, Currency Analyst for DailyFX.com for an interview with FX Street.

To contact David, e-mail dsong@dailyfx.com. Follow me on Twitter at @DavidJSong

To be added to David's e-mail distribution list, send an e-mail with subject line "Distribution List" to dsong@dailyfx.com.

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