Commodities have come under broad pressure in the past couple of weeks. Oil prices in particular have been facing headwinds, and have fallen from $147/bbl to $125/bbl, but metal and food prices have also cor-rected. Corn, for example, has fallen almost 20% from its peak in late June. Lower commodity prices are good news for the world's central banks, not least the ECB and Sweden's Riksbank, which have been heavily fo-cused on headline inflation.
Oil is the commodity benchmark - and sentiment has shifted. The players in the oil market have suddenly re-alised that the global economy is starting to react to elevated oil prices. Not only has the economic slow-down deepened in the US, it has also spread across the Atlantic to Euroland. The US is still the world's largest consumer of oil, but US petrol consumption is now 3% down on a year ago and the number of kilometres driven has fallen 3.7% y/y. Airlines have cancelled routes and grounded planes. However, the clearest il-lustration of how expensive oil has affected behaviour is probably large pick-up and SUV sales - which are down a whopping 30% compared to six months ago. Americans are beginning to react to the hefty hikes in oil prices by buying smaller more fuel-efficient cars and travelling less.
This "demand destruction" will probably continue in the coming months, and oil prices could well fall further. Looking ahead to 2009, however, this does not alter the picture of a still rather tight oil market. Demand for oil remains buoyant in Asia and the Middle East, supply still has problems keeping up, and prices probably do not have to sink much further before OPEC begins to consider cutting back production. Nevertheless, the fact that demand is now being affected by the higher prices means that one can confidently dismiss the doomster prophecies of oil at $200 or higher in the coming year.
Euroland: ECB will wait and see
Data released since the previous publication of Weekly Focus generally indicate that Europe is heading for a slowdown - a slowdown that could become a recession if business confidence continues to slide (see Euroland: Surveys smell of recession). Annualised inflation, meanwhile, does not appear set to ease anytime soon, as the recent fall in the price of oil will take some time to feed through. June saw consumer prices rise by 4% y/y, and the first estimates of the July number indicate an increase to 4.1 % y/y. We expect that in-flation will hit a peak of 4.2% y/y in the course of Q3.
The main event of the coming week will undoubtedly be Thursday's rate decision from the ECB. Like the market, we expect that the ECB will keep interest rates unchanged at 4.25%, after hiking by 25bp at its July meeting on fears of second-round effects on inflation. The ECB now expects that inflation will not moderate towards the central bank's target rate of 2% until 2009.
As we wrote in Global: Inflation expectations monitor, both consumer and market implied inflation expecta-tions are rising in most of Europe. On top of this comes a fear that administered prices will be raised due to the recent increases in commodity prices. This is putting pressure on the ECB to hike rates. That said, help is perhaps at hand in the shape of the commodity market losing some steam - oil prices are down $24 from $145/bbl at the start of July, and food prices too have begun to ease. Nor can the ECB have failed to notice the past month's weakness in business confidence, which would again ease the pressure to hike.
We do not expect the ECB to alter its rhetoric from the July meeting. Instead it will wait and see if inflation will start to retreat on the back of the slide in commodity prices. However, a nod in the direction of the weak growth data could be on the cards. Speeches by members of the ECB have been thin on the ground of late, but those that have been given have generally expressed satisfaction with the current level of interest rates. This is also reflected in the markets' expectations, with just a 33% probability of a rate hike before the end of the year priced in.
Key events of the week ahead
- Thursday's rate decision is event of the week.
- German trade figures on Thursday will reveal if ex-ports are still under pressure.
- Italian GDP is scheduled for Friday, and might give some indication for the direction of Euroland GDP.
Switzerland: A look back at July
It is four weeks since the last issue of Weekly Focus, so there is good reason to take a look back at the most important events in the Swiss market over the past month. Macroeconomic data have generally been on the weak side, and a look at how incoming data have compared with consensus expectations (as illustrated by the "surprise index" in the chart below) shows that the market has also generally been disappointed. This was confirmed most recently by an unexpectedly sharp drop in the KOF leading indicator, which fell to 0.90 in July, dragged down by a weak outlook for domestic consumption, whereas the financial sector seems to have stabilised. Besides relatively weak activity data, consumer price inflation in Switzerland remains high, hitting 3.1% y/y in July, the highest rate for almost 15 years. Once again inflation was fuelled by higher prices for energy and other imported goods.
All in all, the data for July confirm our view of the Swiss economy: (i) the economy has peaked and growth is expected to slow significantly; (ii) inflationary pressures have mounted, albeit less markedly than in Euro-land; and (iii) the labour market is still strong but indicating an imminent downturn.
This situation was reflected in the financial markets in July. Swiss yields fell, primarily on instruments with short maturities, and so the yield curve has steepened. The yield spread to Euroland (2Y swap yields) hit a new peak of 198bp the day before the ECB raised its key rate by 25bp on 3 July, but has since narrowed again and is currently at 188bp. This narrowing of the spread is mainly due to the market no longer dis-counting further interest rate hikes from the ECB. The market is, however, pricing in at least one further 25bp hike from the SNB in the next year, with a 28% chance of the SNB raising its target range by 25bp at its September meeting.
Movements in the FX market have been rather surprising. CHF fell 1.5% against EUR in July, sending CHF/DKK down from 4.63 to 4.57, and was second only to the NZD as the worst-performing G10 currency against EUR over the month. This was a surprise, as there were only comparatively small movements in relative yields, whereas there were broad falls in the stock markets. This should have led to a stronger CHF, as historically the CHF has performed when stock markets fall. However, this was not the case in July, which indicates that the negative correlation between CHF and the stock market has weakened recently.
Key events of the week ahead
- Monday brings the PMI for the manufacturing sec-tor.
- On Friday it will be interesting to see whether there are again early signs of weakness in the Swiss la-bour market
USA: Fed to signal lengthy period on hold
The big event of the week stateside is the FOMC's rate-setting meeting on Tuesday. In line with both the market and the consensus of analysts, we expect the Fed to leave the funds rate unchanged at 2.0%. As the interest rate decision is therefore largely a given, the focus will instead be on the wording of the accompa-nying press release.
This will make particularly interesting reading in the light of the growing disunity on the FOMC (see Flash Comment - FOMC: Hawks and doves in bird-fight, 17 July). In his semi-annual testimony to Congress in mid-July, Fed chairman Ben Bernanke stepped up the emphasis on growth concerns in the light of the financial crisis (see Flash Comment - FOMC: Growth concerns return, 15 July). However, several of the hawks on the FOMC have since been putting out a very different message, arguing strongly that mounting inflation risks warrant the tightening of monetary policy sooner rather than later. This disunity means that the press re-lease will necessarily end up a compromise between the two camps. That said, it would not come as a sur-prise if one or more of the hawks vote against the interest rate decision.
However, the doves are still in the majority on the FOMC, which gives good reason to expect a moderate statement sticking relatively closely to the message in Bernanke's testimony. All in all, this means that there will be slightly greater emphasis on the downside risks to growth than after the last FOMC meeting, while inflation concerns will be kept at a high but unchanged level. The FOMC is therefore expected to signal that the current funds rate is appropriate in terms of inflation and growth risks, but that the outlook is sub-ject to considerable uncertainty.
We still expect the Fed to stay on hold well into 2009. Generally speaking, we find it hard to see the Fed normalising monetary policy for as long as unemployment is rising, house prices are falling and financial markets are fragile. The latest drop in commodity prices may also help allay inflation fears in the coming months. Against this background, the market's pricing in of a 30% chance of an interest rate hike in Sep-tember seems a tad aggressive to us (see also Fixed Income article).
Key events of the week ahead
- The Fed's Senior Loan Officer Opinion Survey on Bank Lending Practices.
- Tuesday: Core PCE deflator will climb 0.3% m/m or 2.3% y/y in June.
- Tuesday: The FOMC will leave the funds rate at 2.0% and deliver a neutral press release.
- Friday: Unit labour costs will climb 1.4% q/q AR or 1.4% y/y in Q2.
Foreign exchange: No news is good
The economic data in recent weeks have been exceptionally bad, and almost no matter where one looks, the risk of recession appears to be rising - a few arbitrary examples include record low consumer and business confidence, falling housing market activity, weakening retail sales and production, and rising in-ventories. The slowdown is being led by the G3 (USA, Japan and Euroland), though countries such as the UK, Australia and New Zealand also look rather vulnerable. The driving forces of the slowdown should be pretty well known by now: tighter credit, rising energy and food prices, and shrinking wealth due to tumbling equity and house prices. Moreover, there is no reason to expect a turnaround anytime soon. Instead, one should anticipate a significant lowering of expectations for economic growth in the coming months. Emerg-ing Markets too appear to be hitting the brakes, with the noticeable exception of China. Overall, our theme of a global slowdown is still very much alive and kicking and, if anything, recession fears should increase going forward. This also means that markets will probably shift their focus from inflation back to growth.
July saw further significant underperformance by the finance sector, and the bank sector seems to throw up new problems almost daily. In a nutshell, the driving force here is a shift in the liquidity and housing mar-ket cycles that would appear set to continue for some time yet. Our theme concerning a financial crisis therefore looks likely to be relevant in H2 08 as well.
The weakest G10 currency in the past month has been NZD, which pretty much matches our forecasts. Last week, New Zealand cut its rates by 25bp to 8.0% - the first cut since 2003. The cut came a couple of months earlier than we had expected, but the direction was no surprise. The kiwi economy is slowing rap-idly, and a shift in monetary policy almost always spells trouble for an overvalued currency carrying a sig-nificant current account deficit. As NZD is being hit by both the above-mentioned themes, we expect to see further weakness in the coming months.
In our latest forecast update on 4 July (see FX Forecast Update: To catch a rising tide), we lifted our 3M forecast for EUR/USD to 1.60 (from 1.55) and 6M forecast to 1.55 (from 1.50). The 1.60 target was reached already on 15 July, but has since retreated to 1.56 at the time of writing. Three factors suggest the euro could have peaked for now. First, oil prices have fallen a good 15%. Second, the US has taken further steps to ease the problems plaguing the housing market. Third, economic data out of Euroland have been alarmingly weak. We have no doubt that the outlook for the US in the coming year is troubling - to put it dip-lomatically. However, relatively speaking, the downward movement in Europe is now clearly more pro-nounced and the downshift here has only just started. With inflation running at 4.1%, the scope for the ECB to turn soft on its inflation mandate is limited, though a more aggressive pricing of rate cuts in 2009 will probably coincide with a cyclical turning point for EUR/USD. Technically, the pair has been trading within a broad range between 1.53 and 1.60, which has held since March.
Fixed Income: Monetary policy meetings in focus
In Euroland, bond yields have been edging lower and the curve has been steepening over past 3-4 weeks. This largely reflects less concern about the inflation outlook and in turn reduced expectations for further ECB hikes this year. Currently, the market is pricing in around a 15% probability of another ECB hike this year. Given the deteriorating economic outlook and the slowdown in commodity prices, we judge the current pricing as being close to fair. Going forward, the risk is for more steepening and lower bond yields, but the size and speed of such a move will largely depend on ECB rhetoric. Next week's ECB meeting (Thursday) will be the key event in European bond markets. We expect the central bank to keep rates unchanged at 4.25% and to re-iterate inflation concerns but also give a nod to the deteriorating economic data (see Euroland section). With the bulk of the hike expectations already removed, we do not expect the meeting to prompt any major reaction in the market. Hence, as long as the ECB sticks to its inflation-fighting rhetoric, any fur-ther declines in bond yields will occur at a slower pace going forward.
While very volatile, the US bond market has basically been moving sideways in July - and this despite Ber-nanke's reinstatement of significant downside growth risks in his congressional testimony in mid-July. On balance, the economic data have been slightly better than expected, although the outlook for H2 remains pretty negative, as the tax rebate boost to consumers will be fading soon. Moreover, several hawkish speeches from regional Fed governors have helped keep alive market fears of an early monetary policy re-versal. Finally, supply concerns in the Treasuries market amidst a deteriorating US budget outlook have kept the curve buoyant - particularly at the long end. We still believe that the current market pricing of a 60% probability of a hike this year is too aggressive. We expect the Fed to keep the policy rate unchanged at 2.00% at Tuesday's FOMC meeting and the statement to closely resemble the message from Bernanke's testimony, ie, that the Fed is firmly on hold. On balance, we think such an outcome could produce some bull-ish steepening in the US Treasuries curve.
Aside from the ECB and Fed meetings, the rate decision from the Bank of England (Thursday) will also at-tract attention in the fixed income market. We look for an unchanged policy rate of 5.00%, but continue to expect monetary easing further down the road.
Danske Bank http://www.danskebank.com/danskeresearch
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