Another focus point in the crisis has been the ailing bond insurers. As the last of the three large rating agencies Moody's yesterday slashed the Aaa ratings of the largest bond insurers MBIA and Ambac. This puts an end to the AAA era of the major bond insurers as S&P and Fitch earlier cut their AAA ratings on the bond insurers. The major effects from bond insurer downgrades have in our opinion occurred (when Fitch and S&P reacted) although the initial market reaction was somewhat negative in a weak market, see Weekly Credit Strategy.
Going forward we are looking at a more traditional negative swing in the credit cycle, and we expect continued elevated volatility. We remain cautious as we think the ongoing tensions in the money markets, significant tightening of lending standards, as well the deteriorating signs from the real economy will weigh on spreads.
Euroland: Signs of weakening in Germany
We have seen few data out of Euroland during the past week. The most important news data was a significant weakening of the ZEW sentiment indicator from -41.4 to -52.4 - its lowest level since December 1992. The drop in sentiment was partly due to leaner order books in manufacturing. This suggests the German economy will slow further during the next six months. The May inflation number for the euro zone was revised upwards by 0.1%-point to a 16-year high of 3.7% y/y. Core inflation edged up by 0.1%-point to 1.7% in May. However, the high food and energy prices do not yet seem to have fed through into core inflation (see Research - Euroland: Core inflation contained, but not for long). Early next week we will get a clearer picture of the temperature of the German economy when the PMI and Ifo numbers are released. We shall also watch out for the PMI data for France and the entire euro zone.The coming week will moreover see the release of economic data for France. Tuesday's housing starts and permits will show whether construction is still plummeting, and the business confidence indicator, which normally tracks the PMI closely, will contribute to the overall picture of the French economy. The focus of attention will turn to French consumers Thursday, when confidence and consumption indicators are due out. Last month, French consumer confidence dropped to its lowest level ever, and consumption also came out weak.
Inflation data for Germany and Spain, together with Thursday's M3 data, will contribute some of the last pieces of the puzzle ahead of the ECB policy meeting on 3 July. The central bank has clearly signalled a rate hike of 25bp. It would risk losing credibility if it does not "deliver", and we do not believe that the above activity indicators will come out sufficiently weak to make the ECB hesitate. We expect the bank to hike rates by 25bp in July and then to go on hold. However, uncertainty is looming exceptionally high, since we have never before seen the ECB ease policy when the economy is slowing down.
Key events of the week ahead
- Monday: Ifo indicator. We expect the overall index to come out at 102, so we are expecting a bigger fall than consensus. Euroland manufacturing PMI is expected to come out at 50.1 and services PMI at 50.6.
- Thursday: M3 for May and French consumer expectations and data.
- During the week: Inflation data for Germany and Spain, as well as construction starts and permits.
Switzerland: Unchanged monetary policy target range
The coming week brings important confidence indicators for both Swiss producers and Swiss consumers. Until then the market will probably first need to digest last Thursday's quarterly monetary policy meeting at the SNB, which decided to leave its monetary policy target range unchanged at 2.75% ±0.5pp. This came as no surprise, being both our own expectation and the consensus forecast. However, there was more uncertainty about the outcome than usual in the run-up to the meeting, and a number of players in the market expected a 25bp hike. They were left disappointed, and both yields and the CHF fell after the meeting. The CHF/DKK is now trading back at the level seen at the start of the month.While the decision to leave interest rates alone came as no surprise, the ensuing press release did - by being relatively neutral. Although the SNB revised its inflation forecast up substantially as expected, the press release did not give any clear signal of a change in monetary policy. Instead the SNB said that it considers the current high rate of inflation to be transitory, as the current rapid rise in energy and food prices is not expected to last. Thus the SNB, unlike the ECB, appears to be willing to live with a very high rate of inflation this year without tightening monetary policy. The SNB did, however, note that it will be keeping a close watch on inflation, and that a weaker CHF, higher-than-expected economic growth, higher energy and food prices, and an increase in inflation expectations could prompt a reaction (in other words, tighter monetary policy). We still consider a rate increase to be the most likely outcome of the September meeting, and the expected hike from the ECB in July will indirectly put pressure on the SNB. If both the ECB and SNB deliver a hike during the summer, the monetary policy spread will be unchanged.
Confidence indicators dominate the calendar in the coming week, although it begins with an updated forecast from the State Secretariat for Economic Affairs (SECO). Tuesday brings the consumption indicator for May, which we expect to fall. The signal from the indicator has been largely unchanged over the past year and has to be expected to fall back now that the economy has peaked. Finally, Thursday sees the KOF leading indicator for June, which we expect to continue its downward trend, albeit with a smaller drop than in previous months. The current signal from the KOF ties in well with the SNB's forecast of real GDP growth of 1.5-2% in 2008. We do not expect the coming week's data from Switzerland to move the financial markets, though, and so the CHF will probably continue to be driven by changes in general risk appetite.
Key events of the week ahead
- Monday: Updated forecast from SECO.
- Tuesday: UBS consumption indicator.
- Thursday: KOF leading indicator for June. It is worth noting that the KOF has not moved the FX market much in recent times, despite springing big surprises
UK: Retail sales surprising again
UK retail sales surprised to the upside yet again, rising 3.5% m/m in May, leading to an annual rise of 8.1% (see "Flash Comment - UK: Very strong retail sales"). The number is surprising in two ways: 1) Surveys have been weak across the board with both the Distributive Trades Survey and the BRC survey pointing to retail sales growth around 1%, 2) Fundamentals for UK consumers are weak, with real income growth falling strongly as a consequence of higher inflation and rising unemployment. The strongest decline in house prices in at least 15 years is also weighing on consumers.This view of a puzzle is shared by the Bank of England, which in the past week wrote the following in minutes from its latest meeting: "In the United Kingdom, the official ONS data had presented a rather puzzling picture of relatively strong consumption. But other evidence, including business surveys, reports from the Bank's regional Agents, and Committee members' own discussions with businesses around the country, pointed to a slowdown in consumption which was likely to continue into the second half of the year. Given that the survey and anecdotal evidence had mostly been for April or May, and some had been forward-looking in nature, the MPC judged that it was most likely that growth was on track to slow in the second quarter, consistent with the May Inflation Report projections."
The risk of a hike is rising in the short term, but we still believe it to be below 50%. We believe the Bank of England wants to see more data before putting too much emphasis on it. And we expect hard data on retail sales to eventually come in line with the surveys and fundamentals. Markets are again pricing about 75bp of hikes after the number, which we find overdone. Even if they would hike once we doubt it would be a new series of hikes. As long as the outlook for the UK economy is deteriorating, we expect GBP to remain under pressure. Today's strong numbers do not change our anticipation of EUR/GBP going towards 0.82 in the late summer or the beginning of autumn.
Key events of the week ahead
- Data for house prices are released on Monday (Rightmove) and Wednesday (Nationwide). In the coming months, the recent rise in rates will add to the pressure of UK housing.
- Tuesday data for BBA loans for house purchases are released.
- On Wednesday, the Distributive Trades Survey will add more pieces to the "retail sales" puzzle.
US: Rate-setting meeting at the Federal Reserve
As we have highlighted in recent weeks, both central banks and the markets have been gripped by inflation fears, especially given signs that inflation expectations may have started to climb. Meanwhile, incoming economic data have not been quite as bad as expected, and so the latest utterances from Federal Reserve chairman Ben Bernanke suggest a certain shift of focus away from the downside risks to growth and back towards inflation risks. In this light, the coming week's rate-setting meeting is of particular interest.Although it is a pretty safe bet that the FOMC will leave the federal funds rate unchanged at 2%, there is considerable uncertainty about what signals the press release will send out. A clear shift in the Fed's communication is likely, but how strong a shift depends entirely on how the balance between the doves and the hawks on the FOMC has changed since last time around. There is undoubtedly broad disagreement between the different camps on the FOMC, and so the statement will always be something of a compromise.
While the press release generally provides a pointer as to where interest rates are headed, the FOMC has chosen not to do so several times in the past when there has been great uncertainty, and this may very well be the case again this time around. If there is an explicit signal, we reckon that the FOMC will opt to be relatively cautious. The economy is still weak, and the financial markets fragile. The inflation outlook also depends heavily on oil prices, which can change very quickly. It therefore seems most likely that the rhetoric will not be tightened to any great degree. In other words, there will be no clear signal of higher interest rates around the corner.
Comparing this with market expectations, which discount almost a full 25bp hike in September and total increases of 125bp over the coming year, we think there is a risk of the markets finding the statement a tad soft. This could reduce expectations of imminent rate increases. We still expect the Fed to stay on hold for some time. We do not expect the normalisation of monetary policy rates to commence until summer next year.
Key events of the week ahead
- Wednesday: Durable orders and new home sales. The latter are expected to drop 5% m/m to 500,000.
- Wednesday: The FOMC is expected to leave the fed funds rate at 2%. The focus will be on the press release.
- Thursday: Existing home sales are expected to be unchanged at 4.89m.
- Friday: PCE core inflation of 0.2% m/m.
- Friday: Michigan inflation expectations.
Asia: Monetary policy tightening beginning to work in China
We have now had most of the data from China for May, and they have not significantly changed our view of the Chinese economy. The data are associated with some uncertainty, as the traditional May Day holiday was cut for the first time this year from six to three days, which may have artificially inflated this year's figures. But the general picture of the Chinese economy appears to remain one of unchanged to slightly slower growth. As we wrote last week, there are not yet any signs of a significant downturn in exports. We still think that this will come later in the year, though. Private consumption still looks very strong despite the latest rise in inflation. Real retail sales grew by 14.3% y/y in May, which needs to be seen in the light of growth below 12% y/y in 2007 as a whole and generally below 10% y/y in the first half of the decade. It therefore seems that the consumption ratio in China is finally on the up after many years in decline. The reason is probably a combination of rising wages and the ongoing expansion of the Chinese welfare system.On the other hand, investment growth seems to have slowed slightly. Fixed investment in urban areas is currently growing at around 17% y/y, down from more than 21% y/y in 2007 as a whole. The Chinese government's tight management of bank lending since the start of the year therefore seems to have had some effect. It is primarily the property market that is being hit by tighter credit conditions. During the first four months of this year, turnover in the property market fell by 2% y/y, after climbing 44% y/y in 2007 as a whole. House prices have also begun to slow, as can be seen from the chart below. It therefore appears that the Chinese property market is cooling at a very opportune time, as the rebuilding needed after the Sichuan earthquake could otherwise have pushed an already overheating construction sector past breaking point.
The overall picture, therefore, is of a Chinese economy shifting down a gear. The past week's price hike for energy products will put a further dampener on growth (see Commodities article). Whether growth will slow sufficiently to take the inflationary pressure out of the economy is still uncertain, as this is heavily dependent on exports. Although real interest rates are currently less than -3% in China, it would be wrong to conclude that Chinese economic policy is flawed and unsustainable, as it is lending quotas and not interest rates that are currently the most important monetary policy instrument. In the longer term, of course, there will be a need to raise interest rates a long way if the government wishes to liberalise the financial sector. But it will be difficult to do so for as long as China chooses to track USD, and the market is expecting marked appreciation of CNY.
Key events of the week ahead
- Friday brings Japanese consumer prices for May. We expect a sharp rise, due partly to the reintroduction of a petrol duty in May.
- Friday also brings Japanese unemployment figures. We expect an unchanged rate of 4.0% in May.
- No important data expected from China in the coming week.
Foreign Exchange: GBP and CHF leaving a busy week behind - new challenges ahead
The British pound has been one of the most volatile currencies against the euro this week. Tuesday's British consumer numbers showed that prices are rising at a 16-year high. Hence, BoE Governor Mervyn King had to write a letter to the Chancellor explaining why he had failed to keep a lid on prices, what the chances were of putting inflation back on track and what the central bank would do to bring down inflation. While the letter mostly had to be written as a matter of form, its contents should definitely be taken seriously. Inflation will remain uncomfortably high throughout this year. Together with the weak outlook for the UK economy, this has placed the Bank of England in a tight spot. On the one hand, the bank feels tempted to hike rates to dampen inflationary pressures; on the other hand, it sees a need for lower rates in order to stimulate the economy.However, Thursday's retail sales data for May made very encouraging reading. The exceptionally warm weather had tempted many people out of their homes, so food sales were higher than normally and clothing sales also rose considerably. The financial markets interpreted the good news as a sign that prices would be raised even further at the shops and that the BoE would therefore have to hike rates to match prices. We are not so sure about this. The encouraging retail sales data were a one-off and do not justify any major conclusions. All surveys point towards a very dull outlook for the UK retail trade industry. Moreover, the housing market is very fragile and a downturn in prices is looming. To top it all, the financial industry, which is so important for the UK, is still weak. Therefore, we continue to expect the BoE to stay on hold for the rest of 2008 and to cut rates next year. As such, we believe EUR/GBP could rise to 0.80 during the next few months (with GBP/DKK falling to 9.32)
The Swiss franc, together with sterling, took centre stage in Thursday's trading, when the Swiss central bank, the SNB, held its quarterly interest rate meeting. Relative interest rates and risk appetite have driven the Swiss franc this year. EUR/CHF is down a little from the year's beginning but has fluctuated heavily. For instance, the Swiss franc strengthened significantly against the euro early this year and until the credit crisis peaked in mid-March, but then fell back. Going forward, a number of indicators point towards a stronger CHF but also indicate significant risks ahead.
We expect economic growth in Switzerland to continue to outpace Euroland both this year and next, although the growth gap will fall. Moreover, we expect inflation to remain lower in Switzerland. All else equal, both of these factors should put downward pressure on EUR/CHF. Also, CHF is still significantly undervalued against EUR judging from longterm estimates. However, these factors obviously are most relevant on a long-term horizon. In the short term, we still expect relative monetary policy and equity market sentiment to drive CHF. Especially relative monetary policy has the potential to drive EUR/CHF in the coming months, with uncertainty looming high for both the SNB and ECB. On Thursday, the SNB chose to keep rates unchanged and to maintain a relatively neutral bias (see Switzerland section). However, we still believe that risks are biased towards a 25bp rate hike in September. On the other hand, the ECB has clearly signalled its intention to hike rates at its July meeting, which will cause a short-term widening of the policy rate spread, while also causing spreads to widen at the longer end of the curve if the SNB fails to hike rates in September. So, upside risks to EUR/CHF have increased considerably in recent months. However, we still expect EUR/CHF to drift slightly lower towards 1.60 over the next three months (CHF/DKK rising to 4.66) and to trend further downwards on a long-term horizon.
Commodities: Coordinated action to bring down oil prices?
China has announced that it is raising diesel and petrol prices by up to 18%, with immediate effect. Chinese fuel prices have long been below world market prices due to heavy subsidies, and so the country's consumers have not been hit by the recent increases in energy prices - Chinese prices have not risen for eight months. On the other hand, this is the largest price hike ever. Although Chinese energy consumption is still markedly smaller than, say, that in the US, China has been one of the main reasons for the rise in oil prices, as demand growth there has been so strong. This year, China will account for about 40% of the extra oil needed in the world market. However, the price hike means that there is the prospect of demand growth shifting down a gear.The big question is how great an effect it will actually have. In recent years there has been a strong incentive for Chinese refineries not to produce more petrol and diesel for the domestic market than they have to. The refineries have quite simply been running at a loss, as the authorities have only partially compensated them for artificially low retail prices relative to the world market price for crude. This has led to shortages of petrol and diesel in China on several occasions. With this new hike in fuel prices, though, it will be more attractive to produce petrol and diesel for the Chinese domestic market. On balance, though, we expect the outcome to be a reduction in Chinese demand growth.
It is no big surprise that the Chinese are reducing their subsidies, but the timing has caught the market napping. Most analysts expected the regime to wait until after the Olympics in order to reduce the risk of Chinese protests about rising energy and food prices during the Games. The price hike also means that China will see higher inflation, which will put a dampener on private consumption and so impact negatively on economic growth.
The Chinese price hike comes ahead of the weekend's summit of oil-producing and oil-consuming countries in Jeddah. The question is whether the Saudis - the only OPEC producer with spare capacity - will be willing to put more oil on the market after stepping up production by around 0.3mb/d to 9.45mb/d in June. If the Saudis do not release more oil, or agree to only a modest increase in production, the reaction may be a further rise in prices. This would seriously fuel speculation that the Saudis are about to run out of spare capacity.
However, one might suspect that the Chinese price hike has in some way been coordinated with the Saudis. The Chinese are curbing their demand growth, and the Saudis are proving that they can actually put more oil on the market. We therefore think that oil prices could very well fall further in the short term beyond the USD 5/bbl drop following the Chinese announcement. The risk of oil prices escalating further over the summer has subsided.
We have long been predicting oil prices just above USD 130/bbl in Q3 and Q4. Given the latest price increases in Asia, we have become more convinced that oil prices will simply not continue to soar in the coming months. In reality, the risk in our forecast is now on the downside. This comes as a major shot across the bows for all the speculation that oil prices are headed for USD 200/bbl in the next 12 months.
Full Report in PDF
Danske Bank http://www.danskebank.com/danskeresearch
Disclaimer
This publication has been prepared by Danske Markets for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Markets' research analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for private customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S, which is regulated by FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange. Copyright (©) Danske Bank A/S. All rights reserved.
