FX Briefing
Highlights
- In Q2 GDP in the eurozone could have fallen for the first time
- Sentiment indicators show sustained downswing in the eurozone
- Only a matter of time until ECB adjusts restrictive stance
Eurozone: Economy Down, Euro Down
The euro is losing steam. It did not even manage to breach 1.60 in mid-July when the credit crisis intensified in the US. Since then, the euro has been weakening. Towards the end of the week, it had fallen to a mere 1.56.
The euro's movement is not based on the dollar strengthening: the problems in the housing market and the financial sector are still weighing on the US economy. In the second quarter, GDP growth accelerated somewhat to an annualized 1.9%, but this was due to the 100 billion dollar stimulus package, still robust foreign demand and non-residential construction, which shot up unexpectedly. All these factors are temporary. We are therefore expecting US economic growth to be sluggish at best in the forthcoming quarters.
It can be assumed that forex markets have priced in the US crisis to a large extent. The potential for disappointment and hope are more or less evenly balanced. An economic slump in Europe resulting in monetary policy loosening has not been priced in, however. But there are increasing signs that developments could be heading in that direction.
It now looks very much as though the second quarter could turn out to be the first quarter with negative growth ever since the introduction of monetary union. Admittedly, this is partly due to special factors, mainly in construction investment, but the weakness in private consumption has undoubtedly played a role too: in the second quarter, retail sales in Germany slumped by 2.4% in real terms, and in Spain by 2.3%. It looks as though they dropped in Italy too; in France, expenditure on manufactured goods stagnated. But on the production side, things do not look rosy either: Production in the eurozone (excluding construction) has been moving sideways since summer 2007. In May, it was below the previous year's level. The slight increase in Q1 will probably have been wiped out in Q2.
The results of various national surveys and that of the EU Commission confirm that economic activity in the eurozone is falling sharply. The EU Commission's Economic Sentiment Indicator (ESI), which reflects both business and consumer economic sentiment, declined in July from 94.8 to 89.5. This is over 10% below the long-term average (=100) and corresponds roughly with the record lows reached during the recession of 2001 and 2002.
The chart shows that there is a strong correlation between the ESI and GDP growth in real terms in the eurozone. According to the current level of the ESI, real GDP growth in the third quarter could fall to less than 1% year-on-year. This would be in line with our growth forecast, in which we predict that Q3 will be another negative quarter. This picture is confirmed by “hard data” such as most production and consumer indicators (particularly retail sales). The sustained decline in industrial new orders is also pointing in that direction.
With the prospect of a significant growth slowdown in the eurozone, the ECB will see inflation risks diminishing. Moreover, the central bank will have been relieved at the recent fall in oil prices to below $125 per barrel. However, for the time being, the ECB is not likely to be in any hurry to alter its restrictive policy stance: firstly, interest rates were raised only a month ago; secondly, oil prices have just dropped back to their mid-May level, on which the last projections had been based. And finally, the growth slowdown must, up to a point, be regarded as welcome from a monetary policy point of view.
Against this backdrop, we are expecting the ECB Council to note the increasing growth risks at next Thursday's meeting, but to basically confirm its monetary policy stance (no interest rate bias, inflation risks prevail). It is, however, only a matter of time until this changes: inflation rates will begin to fall in the next few months, and there will be increasing signs of a downswing. We expect the forex market to price in this development and EUR-USD to fall significantly below 1.55.
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