European bond markets have been remarkable this year as focus has shifted back and forth between financial crisis/weak growth and inflation. In the first quarter, focus was entirely on the acceleration in the financial crisis. The Fed was cutting rates aggressively and by the end of the first quarter the European market was pricing in 100bp of rate cuts from the ECB within a year.
In the second quarter, things swung dramatically the other way. Financial markets calmed while oil prices rose substantially. This shifted focus 180 degrees onto inflation, which suddenly became the main worry and prompted the ECB to announce a July hike. Within three months, the market went from pricing 100bp of cuts to 100bp of hikes within the next year.
Now we are in the third quarter, and the pendulum is shifting back toward a focus on growth. Oil and other commodity prices have retreated, dampening inflation worries. At the same time, the data in Euroland have weakened substantially - most notably in Germany, where indicators now suggest the economy could be on the brink of recession. This is what sparked the sudden shift in ECB rhetoric at the meeting on Thursday, when it softened its assessment of the growth outlook. The market, meanwhile, is now again pricing in a rate cut next year, and going forward we expect market focus to remain on the weak growth situation. In our view, rising unemployment and more soft surveys will result in the market pricing in more rate cuts - and hence bond yields should fall further and the yield curve should steepen again. This will be reflected in our revised yield forecast next week.
Euroland: "Profit warning" from ECB
After the recent weakening of data it was a matter of when and not if the ECB would soften its assessment of the growth outlook. The ECB has until recently hung on to a quite rosy view of the Euroland economy - despite the massive headwinds piling up this year. But reality has finally caught up with ECB, and it decided to change its assessment of the economy at the rate meeting on Thursday. The ECB said that "downside risks to growth have materialised", which clearly points to a downward revision to the growth projection when it is published in connection with the September meeting.
So what tilted the bank? We believe the sudden shift in the German economy over recent months has been decisive. During the spring the German ifo survey held on to quite decent levels, and this underpinned the ECB's more positive view despite the weakening seen in many other countries, particularly Italy and Spain. Over the past few months the German ifo index has dropped significantly, and Germany has shifted from "last man standing" to "last man falling". The weakness in the ifo has been confirmed by hard data such as factory orders and industrial production. These developments show once again just how important an indicator the German ifo is for general sentiment on the Euroland economy - not least at the ECB.
The ECB will likely come under increasing pressure in the coming quarters, as growth appears set to continue to look soft and a new phase of the slowdown with rising unemployment will likely unfold. If commodity prices stay down, inflation should peak soon, and focus will return to growth. We continue to believe the ECB will stay sidelined, as it still sees medium-term price pressures from money expansion and globalisation. Nevertheless, the probability of rate cuts has increased. We expect the markets to price in 2-3 rate cuts (currently one cut is priced) over the coming months, and hence see scope for a further decline in bond yields. Next week, focus will be on Q2 GDP numbers, which will likely be weak. It has already been leaked that German GDP will fall around 1% q/q, and Italy (first to report) reported a decline of 0.3% q/q for Q2 on Friday.
Key events of the week ahead
- Thursday: German and Euroland GDP. Germany is expected at -1.0%, as indicated by leaks recently. After weak Italian GDP we see downside risks to Euroland as a whole.
- Thursday: Euroland inflation released. Final data which include core inflation. Headline expected in line with Flash at 4.1%. Core seen unchanged at 1.8%
Switzerland: Swiss economy treading water
Monday brought us the PMI for July. The overall index confirmed our view of the Swiss economy, namely that a downturn is on its way. The index fell from 54.9 in June to 54.1 in July, its lowest level for three years, although the drop was not as steep as the market had anticipated. Looking ahead, there is reason to expect the index to approach the watershed level of 50. Switzerland is a small, open economy highly dependent on developments in the global - and in particular the European - economy. The European economy's current woes will inevitably impact negatively on Swiss growth. However, that being said, a PMI reading of 54.1 is a high reading in global terms and still points to economic expansion.
Friday saw the release of the Swiss employment report for July. There was little here of note - the labour market is still treading water. Unemployment is still relatively low at 2.5%, and the ratio of vacancies to unemployed - a forward-looking indicator - is still at its highest since 2003, which could indicate that there is still relatively robust demand for labour. However, a global - and domestic - slowdown will naturally exert upward pressure on Swiss unemployment.
There is little in the economic calendar in the coming week. Thursday brings consumer confidence data for July, and it will be interesting to see if these confirm the trend suggested by the latest figures for the KOF leading indicator, where the private consumption sector, in particular, pulled down the overall index.
Key events of the week ahead
- SECO's consumer confidence survey for July will be released on Thursday.
UK: Inflation Report coming up - will Bank of England soften as well?
If BoE Governor Mervyn King had not already gone grey, the recent uncomfortably high inflation figures and worrying growth outlook would have done the trick. CPI inflation is expected to rise to 5%, and a flurry of gloomy economic data in recent months has highlighted that the UK economy is weakening on all fronts. The minutes from last month's BoE monetary policy meeting clearly showed how split the MPC is: Über-hawk Besley voted for a 25bp hike, super-dove Blanchflower opted for a 25bp cut, while the remaining seven members preferred to keep the base rate unchanged at 5.00%. Is there a possibility that some members might shift to the hawkish camp of Besley? The answer is, regrettably, 'yes'. Fighting inflation is the BoEs top priority - and a nationalised bank, a housing market recession and a sagging retail sector do not alter this mandate. Some members (perhaps Sentence or even the Governor himself) might be tempted to fire a 'warning-shot' à la ECB in July to demonstrate commitment and to avoid being mauled afterwards for not anchoring inflation expectations properly. The Governor, who is regarded as slightly hawkish, has previously put himself in the minority and will probably do so again if necessary. Opting for higher rates would, in our view, be a clear policy mistake.
Is there then any chance that Blanchflower could convince some members that the easing cycle needs to be resumed to counter a British recession? Hopefully, the answer is also 'yes' here. Energy prices are rapidly normalising, and deteriorating growth prospects are helping to curb inflationary pressures in the medium term. Some members (perhaps Gieve, who has previously joined Blanchflower, or the new chief economist Dale, who has US experiences fresh in his memory) may see the light and opt for a rate cut. The result, of course, could be an even deeper split in the MPC. Meanwhile, the next Inflation Report due on 13 August should provide a path for inflation given current rates in the market. It will also give a sense of how serious the BoE sees the economic picture at the moment. We agree with the current market pricing of BoE rate cuts of about 50bp over the next 12M. Thereafter, we expect the base rate to be lowered further in order to address real economic problems. As a result, we see the base rate being lowered to 4.00% by the end of 2009.
Key events of the week ahead
- Tuesday: RICS house price survey will likely stay at a very weak level.
- Tuesday: CPI data will likely show a further rise - to 4.2% from 3.8% - due to base effects. It will be some time before inflation falls back.
- Wednesday: Inflation Report is the market mover of the week (see above)
- Wednesday: Unemployment numbers will likely show another increase of close to 20k
USA: Retail sales grinding to a halt
During the past week, the focus has mainly been on Tuesday's FOMC meeting of the US Federal Reserve, which did not, however, deliver any major surprises. In the statement accompanying the meeting, FOMC members expressed a balanced view on the downside risks to growth and upside risks to inflation. Given the continued fall in house prices, rising unemployment, financial market turbulence and the fall in commodity prices over the past two weeks, which will help to dampen inflation, we continue to believe that the Fed will stay on hold well into 2009 (Flash Comment - FOMC: firmly on hold).
The coming week will se the release of both inflation and growth data. The effects of the US tax rebates fed through to the economy faster than we had expected, so consumer spending is also likely to slow down earlier than anticipated. Wednesday's retail sales data for July will give us an idea of how the US consumer is doing. We expect retail sales to fall 0.4% on the month, mostly because car sales dropped significantly in July. If retail sales come out as expected, we doubt the USA will see positive real consumer spending growth in Q3. On the inflation front, we expect consumer prices to increase by 0.4% m/m. Core inflation (ex food and energy) has so far been moderate, showing very few signs of second-round effects, and we expect this trend to continue in July.
Key events of the week ahead
- Wednesday: Look for a fall in retail sales in July, driven mainly by weak car sales.
- Thursday: Core inflation likely to remain moderate in July, at 0.2% m/m.
- Friday: Industrial production growth expected to slow to 0.1% m/m.
- Friday: We expect a modest rise to 61.8 in the University of Michigan consumer confidence index.
Asia: Sharp downturn in Japanese economy in Q2
Hogging the limelight in Japan in the coming week will be the GDP figures for Q2, which will undoubtedly confirm a sharp downturn in the economy. We reckon that GDP will fall 0.5% q/q, dragged down primarily by weaker private consumption and exports. We expect exports to fall 2.5% q/q at constant prices, with net exports reducing GDP growth by 0.4 percentage points. Private consumption will probably drop 0.5% q/q, lopping a good 0.2pp more off GDP growth. The only slight ray of sunshine we are counting on is investment, which we expect to increase slightly thanks to higher housing investment. The outlook for Q3 also looks weak, although the recent drop in oil prices means that private consumption could pick up a little. As investment will probably be weaker in Q3, a second quarter of negative growth can definitely not be ruled out. Our current forecast is positive growth of 0.2% q/q, but there is much to suggest that we may be forced to revise this down.
The Japanese government is also now starting to react to the weak economic data and is expected to table a stimulus package in the coming week. This will probably consist mainly of subsidies for the sectors hit hardest by higher oil prices, in particular transport and agriculture, and are hardly likely to have any great direct economic impact. Due to falling tax revenue, however, there is growing pressure on the government both to drop its target of getting the primary budget balance into the black in 2011 and to lift the JPY 30tr ceiling on bond issues. The Japanese cabinet was reshuffled during the week, and the focus is increasingly on possible elections to the lower house, which have to be held by September 2009.
With the Olympics getting under way, China will be very much in the spotlight in the week ahead. A wide range of data for June will also be released during the week. We expect consumer price inflation to again fall slightly, from 7.1% y/y in May to 6.8% y/y in June, confirming that Chinese inflation has peaked. A conviction that inflation has probably peaked has given the Chinese administration more scope to buoy growth, and there was effectively a slight easing of monetary policy during the week (see Flash Comment - China: No need for more tightening).
Key events of the week ahead
- Tuesday sees Chinese consumer price data for June, which are expected to show another slight drop in inflation.
- Wednesday brings Japanese GDP figures for Q2, which will confirm a substantial downturn in the economy (see above).
- The week will also see Chinese trade figures for June. The PMI suggests a slowdown in export growth.
- The Japanese government will probably announce a stimulus package during the week.
Foreign exchange: A central bank chief's unbearable lightness of being
Do we really have to wait until 2009 before a major central bank changes its rates? Probably yes, as the five largest central banks, the Fed, ECB, BoJ, BoE and BoC, all seem to be trapped between rising inflation on the back of high energy and commodity prices, and a real economic outlook that appears to be deteriorating faster than you can spell stagflation. Thus we expect that the key central bank chiefs will meet with the members of their respective monetary policy committees month after month just to decide that current interest rates are probably appropriate for ensuring that inflation expectations do not run amok and that the conditions for economic growth do not become too difficult. Truth be told, no-one knows - with any great degree of certainty - if the current level of interest rates is in fact appropriate, and nor are central banks shy about highlighting the substantial degree of uncertainty that surrounds the forecasts upon which their monetary decisions are based. Only time will tell whether interest rate levels are appropriate.
For any serious change in interest rates one needs to look down under. Australia and New Zealand, which at 7.25% and 8%, respectively, have the highest key rates in G10, are preparing for a period of declining interest rates. The reasons include a normalisation of commodity prices, which is a drag on these commodity-heavy economies, and generally poorer growth outlooks. Rate cuts will very probably be most pronounced in New Zealand, while it is not entirely sure that Australia will cut this year, although the RBA has begun to flag that this will be the direction going forward. The prospect of rate cuts has already lessened the attraction of carry trades, as the interest rate advantage of being positioned in AUD and NZD after borrowing in lower yielding currencies is now less.
The outlook in Sweden and Norway is still for tighter monetary policy, mainly due to increasing inflation. The somewhat surer bet is that Sweden's Riksbank will hike this year, probably as early as next month, though one cannot rule out Norges Bank hiking its already high level of interest rates before the end of the year. Even after a hike of 25bp to 4.75%, Sweden's key rate would still be a solid percentage point below the current Norwegian rate of 5.75%. A hike in Switzerland also seems plausible, indicating a commitment to anchoring inflation expectations.
Until clearer signals emerge on future monetary policy in G10, currency crosses may lack direction. Exchange rates can also be affected by other factors for shorter or longer periods, such as energy and commodity prices, peripheral economic data, stock markets or general risk appetite - and the result may well be widespread range trading in which the absence of trends is both noteworthy and at times frustrating. Nevertheless, opportunities still exist, though one should go for lower but more numerous profits with limited losses.
Fixed Income: Weak data and falling commodity prices drive European yields lower
In Europe, the trend of falling yields and steeper curves continued over the past week. Thus 2-year yields have fallen by 16bp, while 10-year yields have fallen by 8bp since last Friday. The driving theme behind the decline in yields is still sliding commodity prices and weak economic data, which increasingly indicate a downturn in Europe. Over the summer this has led the market to seriously revise down its expectations of more rate hikes from the ECB.
As expected, Trichet kept interest rates unchanged at 4.25% and restated inflation worries at Thursday's rate meeting. The central bank chief did, however, acknowledge that the growth picture looked weaker. This prompted the market to further tone down its interest rate expectations: there are now no expectations of further rate hikes before the end of the year, while rate cuts are beginning to be gently priced in during 2009 (see graph below).
Looking ahead, the conditions are still in place for lower yields and steeper curves in Europe. The economic data due in the coming week suggest that market focus will remain on the growth slowdown. In Europe, the key releases will be GDP numbers for Germany and Euroland (Thursday) - both are expected to confirm a lacklustre Q2. As there is also the risk of a negative surprise from US retail sales in July (Wednesday), further downward pressure on yields could be on the cards in the week ahead - especially if commodities continue to decline.
Danske Bank http://www.danskebank.com/danskeresearch
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