ECB afterwards tried to calm the markets, saying that they had understood the message for the July meeting but that the ECB was not preparing a series of rate hikes. It is very unusual for the ECB to comment so clearly on market expectations, which makes it all the more noteworthy. But it illustrates how inflation fears are taking hold in the market and the fact that very few participants have any appetite to risk positioning themselves for lower yields, despite the unusually unambiguous comments from the ECB.
The main worry among central bankers is that inflation expectations are showing signs of picking up. We have seen consumer inflation expectations rise in both the US and the UK, and it is clear that they are watching these trends very carefully as they pose a direct threat to their credibility as inflation fighters. We are starting to see central bank hawks talk very loudly, and the markets are starting to price in a potential paradigm shift among central banks in which rising unemployment is outweighed by inflation fears.
Euroland: ECB in the spotlight
The ECB's rate-setting meeting on 5 June set the tone for the past week. Jean-Claude Trichet surprised everyone by saying that it is possible, but not certain, that the ECB will raise its rates at its next meeting on 3 July. Some of the traditional hawks at the ECB were very unsubtle in their comments shortly after the ECB's press conference. For example, Axel Weber said that deeds must follow words. It will now be very difficult for the ECB not to deliver without losing credibility, and the market reacted strongly. Several members of the ECB's governing council have since urged level-headedness. Christian Noyer was quoted in the press as saying that he did not see a clear link between Trichet's comments at the press conference and market expectations. Lorenzo Bini Smaghi said that the ECB's comments concerned only the coming rate-setting meeting, and Jürgen Stark said that the ECB is not talking about a series of rate increases. We expect the ECB to raise rates by 25bp in July and then leave them unchanged. However, there is an unusual amount of uncertainty here, as we have not previously seen the ECB raising interest rates at the same time as the economy is shifting down a gear.Economic data during the week generally supported the chances of the ECB hiking in July. Wage growth in Euroland accelerated from 2.9% in Q4 to 3.3% in Q1, so increasing the risk of the second-round effects that so concern the ECB. In Germany, inflation was revised upwards by 0.1pp to 3.1% y/y in May, and wholesale prices rose by 8.1% y/y, the highest increase since 1982. In France, consumer prices climbed 3.7%, and the HICP in Spain was up 4.7%. In other words, inflation in the euro economies is high. Meanwhile, industrial production was strong in April, growing 3.9% y/y and 0.9% m/m. That said, the April figures were distorted by the early Easter this year. Taking March and April together, growth was just 0.2% m/m, compared with 0.5% m/m in January/February. Underlying growth in industrial production is therefore trending downwards.
The coming week brings the ZEW economic sentiment indicator in Germany. The index for the current situation in particular has recently given a good indication of where the important Ifo indicator is headed. A strong downturn in the Ifo could possibly prompt the ECB to put back its planned hike. The week also brings figures for inflation in Euroland and wage growth in France, Spain and Italy. The latter could provide important information on how the high rate of inflation is impacting on wages in the various economies.
Key events of the week ahead
- Monday brings figures for inflation in Euroland in May. We predict headline inflation of 3.6% y/y and core inflation of 1.8%.
- The ZEW indicator of economic sentiment is released on Tuesday.
- The week also brings wage data for France, Italy and Spain.
Switzerland: Q2 monetary policy meeting
The big event of the week is without doubt the Q2 monetary policy meeting at the SNB. At 09.30 CET on Thursday the bank will publish its monetary policy intentions for the coming quarter and present an updated inflation forecast. In line with consensus, we expect the SNB to leave the 3-month LIBOR target unchanged at 2.75%, although there is the risk of a 25bp hike. In connection with the monetary policy meeting, the SNB will be releasing its Monetary Policy Assessment and Quarterly Bulletin, where the current monetary policy situation and an updated inflation forecast are presented. We expect the bank to revise up its inflation forecast and tighten its rhetoric sufficiently to signal a tightening bias. We have also decided to revise our interest rate forecast for the SNB in line with the latest change in our ECB forecast. Rather than expecting the SNB to lower its target range in H1 2009, we now expect the LIBOR target to be raised by 25bp to 3% at the September monetary policy meeting.The last month has brought a significant change in market pricing of the SNB. The market is no longer pricing unchanged rates, but instead an increase of almost 75bp. A similar movement has been seen in the European market, but while the ECB in a number of speeches has signalled its intention to raise interest rates, the SNB has yet to signal any significant change in its monetary policy intentions - either in speeches or through the one-week repo rate. On the other hand, the high May inflation figures published last week were a significant factor in the change in the pricing of the SNB and in our revision of our SNB forecast. Inflation climbed to 2.9% y/y in May and has now been above the monetary policy target of 2% since December last year. The high rate of inflation has been driven particularly by rising energy prices, and the oil price assumptions underlying the SNB's last inflation forecast no longer seem plausible.
This suggests that the SNB will tighten monetary policy. Also, if the ECB hikes and the SNB does not, the spread to Euroland will increase, possibly leading to a higher EUR/CHF and with it imported inflation. Furthermore, data have yet to confirm a cyclical turn in the Swiss labour market. However, there are also a number of factors that argue against higher interest rates in Switzerland and lead us to expect less monetary policy tightening than is currently being priced in by the market. First and foremost, an interest rate hike from the ECB should not necessarily imply an interest rate hike from the SNB. Inflation is lower in Switzerland and closer to the monetary policy target. In addition, macro data suggest that the economic cycle has peaked and that economic growth is set to slow significantly. This downturn in demand, coupled with favourable base effects, should mean that inflation will drop back in 2009.
We therefore expect interest rates to be left unchanged at the meeting on Thursday, but that the SNB will signal a tightening bias. Our main scenario is that the SNB will act on this bias and raise its target by 25bp to 3% at its September meeting. Assuming that the ECB hikes by 25bp in July, this would leave the policy spread unchanged. We still expect EUR/CHF to fall to 1.60 (CHF/DKK to rise to 4.66) in three months.
Key events of the week ahead
- Monday brings retail sales figures for April. Due to the Easter effect, we expect the adjusted figures to be negative. We predict -6.7% y/y, and we might see a minor effect on EUR/CHF (higher).
- Tuesday offers figures for industrial production in Q1.
- Thursday brings the SNB's Q2 monetary policy meeting. We expect the target range to be left unchanged.
USA: Inflation fears in the driving seat
In last week's Weekly Focus we highlighted the problem of high rates of inflation and the recent signs of inflation expectations being on the way up. Inflation fears are still very much in the driving seat both in the financial markets and at central banks. In a speech on Monday night, Ben Bernanke followed the other Western central banks' lead by further sharpening the focus on inflation. “The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations,” he said, noting in the same breath that the risk of a substantial downturn in the economy had subsided in the past month. This is a clear signal that the Federal Reserve's focus has now shifted towards the upside risks to inflation. As a result, the market has become even more convinced that higher interest rates are imminent, pricing in a whole 25bp hike in September and total hikes of 125bp over the next year.As we wrote earlier this week in our Flash Comment - FOMC: Twisting the focus toward inflation, we still do not expect the Fed to hike for the foreseeable future. The growth outlook and the financial markets are still too fragile for monetary policy to be tightened. The only thing that could change our view is a strong and persistent further increase in inflation expectations. In this case, we could not rule out the possibility of the Fed being forced to deliver one or two hikes as a kind of credibility exercise. Even in this scenario, though, rapid normalisation of monetary policy seems unlikely.
We need to remember that high inflation and the associated increases in market rates are further undermining the growth outlook. Unless oil prices continue to spiral completely unprovoked, it should still be a matter of a relative shift in prices. With time, as the economy reacts to slower growth, this should lead to lower resource utilisation and so lower domestic inflationary pressures. In addition, the US economy is currently reeling from two other major shocks: the downturn in the housing market and the credit crisis. Both of these are, by their very nature, bad news for growth and so disinflationary. They are also being absorbed much more slowly and having more lasting effects than the rise in energy prices. In other words, the current rapid rise in oil prices would have to continue to keep inflation high and hold the markets' attention for any period of time. If, on the other hand, oil prices stabilise, the credit and housing market crises and the soft growth outlook could regain the driving seat somewhere in H2.
Key events of the week ahead
- Monday: Bernanke speaks (Health Summit in the Senate).
- Monday: We expect the NAHB housing market index to drop to 18 in June.
- Tuesday: Data for housing starts and building permits will confirm a further decrease in construction activity in May.
- Tuesday: Industrial production is expected to climb by 0.2% m/m in May.
- Thursday: Philadelphia Fed index is expected to climb to -8 in June from -15.6 in May.
Asia: Higher oil prices and monetary policy tightening to hit growth
For Asia, the original worry for 2008 was that the downturn in the US economy would impact markedly on growth in the Asian economies through lower export growth. To date, this has not happened. The Asian economies' exports have been surprisingly strong, and there has yet to be any real slowdown in economic growth. This was underlined by the Chinese trade figures for May released during the week, which showed an increase in export growth to 28% y/y from 22% y/y in April (see chart). Chinese import growth also accelerated sharply from 26% y/y to 40% y/y. The surge in imports is partly due to the rise in energy and commodity prices and to a temporary increase in imports as a result of the earthquake in Sichuan. However, the strength of Chinese import growth is also a reflection of China having become a key growth engine for both Asia and the global economy.The cost of strong economic growth in Asia has been mounting inflationary pressures. We therefore appear to be headed towards an Asian slowdown driven more by higher inflation and monetary policy tightening. This was confirmed during the past week by a surprise interest rate hike from the Central Bank of India and a further increase in the reserve requirement for Chinese banks from 17% to 18%. This means that the outlook for growth in Asia in 2009 is beginning to look more fragile. Instead of lower growth in 2008 driven by lower exports to the USA, there is increasingly a risk of lower growth in 2009 driven by monetary policy tightening, which typically has more of a delayed effect on growth than, say, a drop in exports.
As expected, the Bank of Japan left its key rate unchanged at 0.5%. The BoJ is one of few central banks that can afford to be relatively blasé about inflation, which is still well within its price stability target range of 0-2%. Japanese monetary policy will therefore be determined primarily by growth, which is expected to be weak in the coming quarters. We do not therefore expect the BoJ to see a need, like the ECB, to accelerate monetary policy tightening in order to curb inflation expectations. Clarification of the global economic outlook is still the key factor for the timing of the next interest rate hike in Japan, which we do not expect before mid-2009.
Key events of the week ahead
- Monday brings Chinese industrial production figures for May, which are expected to show further robust activity.
- Tuesday brings Chinese urban fixed asset investment for May. Here too it has been hard to see any signs of a slowdown.
- Wednesday sees the publication of the minutes of the May and April monetary policy meetings in Japan.
Foreign exchange: An era gone by...
What a week. What a month, a year and perhaps an era. The past week has seen dramatic movements in many markets, not least in rate markets. US 2-year swap rates have risen by 68bp, the largest 5-day gain since March 1985. The main shock to financial markets is coming from rising inflation, actual as well as expected. We have long operated within a strategic framework of a dual shock from a financial crisis combined with a cyclical downturn. As central banks and investors react to higher inflation, inflation must increasingly be viewed as a theme of its own. In brief, rising inflation is not good news. Higher inflation caused by rising energy and food prices translates directly into lower consumer income. Monetary tightening, as indicated by both the Fed and the ECB, together with delayed rate cuts - like in the UK and Canada - or outright interest rate increases - like in Denmark, South Africa and a number of Asian countries recently - also put a damper on the economy. Combined with the ongoing financial crisis, which tends to make banks less willing to lend money, and a turnaround on several housing markets, this point toward a deeper and longer cyclical downturn. We have previously warned against excessive optimism in 2008 and are becoming increasingly concerned about the outlook for 2009. Cyclical downturns are normally negative for UAD, GBP and CAD and positive for EUR, CHF and JPY.Rising inflation also suggests that a low-inflation era could be drawing to a close. Low inflation rates in recent years have made western central banks more willing to experiment with potential growth rates. This experiment now seems to have given way to a more traditional focus on inflation, which, in turn, indicates a shift relative to the awash-with-cash cycle from 2002 to 2007. Increasing inflation in Emerging Markets will contribute to higher global inflation through export prices as well. In as much as EM countries now begin to fight inflation through traditional monetary channels, they might end up with weaker fundamentals and hence higher risk premiums. This is probably, not least, true of non-Japan Asia, where a secular repricing may be underway.
On top of this, we may be on course for a shift in global FX policy. Since the Asian crisis in 1997-98, USD has benefited from a role as a monetary anchor. In what is commonly known as Bretton Woods 2, USD has been the centre of a weak form of currency union that includes a number of Asian, Middle East and Latin American currencies. This has lent monetary credibility to the periphery, while giving the USA easier access to financing its current account deficit. At the moment, Bretton Woods 2 is being hit by two asymmetrical shocks; one in the form of falling US growth, leaving rate cuts and dollar weakness in its wake, and one in the form of rapidly rising inflation at the periphery. Should this situation continue, it may become impossible to maintain the dollar pegs, and result in revaluations of peripheral currencies. All else equal, this would hit the dollar and cause capital flight from the USA following portfolio balancing. We see the latest statements about the dollar from both the Federal Reserve and the US Treasury in this light - not as an attempt to change the rules of the game, but as an attempt to maintain them.
All this leads us to the following conclusions as far as FX markets are concerned: Short-term, we prefer CHF, NOK, EUR and AUD to NZD, GBP and CAD. We cannot find any local arguments in favour of JPY here and now, and we expect JPY to be driven by global factors. Technically, EUR/USD is headed towards 1.52, but we do not expect it to keep falling in the longer term.
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