Capital flows: Market to monitor ECB and Japan money

US monetary policy: QE taper likely to be gradual, barringunexpected data

    US monetary policy has remained the market driver. Long-term yields havefluctuated widely, highlighting how hard it is for the Fed to control marketexpectations: the minutes of the June 18-19 FOMC meeting (published July 10)suggested an early scaling-back of asset purchases, while Chairman BenBernanke emphasized the need for accommodative monetary conditions duringpost-speech Q&A. Our US economics team believes Bernanke's dovish stanceprobably represents the FOMC's baseline view, given (1) the uncertainty abouthow badly or how long fiscal austerity will affect the economy, (2) slower-thanforecastinflation, and (3) the risk that the unemployment rate may reflect acyclical decline in labor-force participation rather than improved supply-demand.

    We conclude that the Fed will scale back its asset purchases only graduallythrough 2014 and that market participants should treat the halting of assetpurchases as a separate issue to exiting the zero interest-rate policy. Bernanke'stestimony on the 17th supported this view.

    Upcoming focus: Eurozone monetary policy and Japaneseinflation expectations

    We expect US data to remain a market focus but new issues may also begin toattract attention once participants have understood Fed monetary policy better.

    One may be the change in the ECB's policy approach: by issuing forwardguidance, the ECB has launched an effort to decouple eurozone monetaryconditions from US monetary policy. However, our European economics teambelieves this guidance will only prove effective if the ECB lowers its policy rate, ifGoverning Council members sing from the same sheet, and/or if the Bankpublishes longer-term economic projections. Technical analysis suggests thepotential for euro depreciation. Stronger forward guidance from the ECB couldprove to be a trigger for this.

    In Japan, signs are emerging that the Bank of Japan's quantitative and qualitativeeasing policy is starting to change inflation expectations: growth in bank lendingand money supply are accelerating, and investment trusts have stepped up theirinvestment in foreign bonds. Provided the Fed continues to move towards a QEtaper, evidence that heightened inflation expectations in Japan are starting tolower real interest rates and boost Japan money (financial investments) could bekey to whether the yen resumes its depreciation.