Paulsen's decision led to a major sell-off in the US mortgage market - not least the sub-prime CDO tranches (see ABX indices). The ABX indices have previously provided a good guide to future write-downs in the banking sector. Hence the recent declines will likely lead to more write-downs and thus a need for further capital injections into the banking system. With private investor interest still very muted, this capital will most likely have to come from the government. Hence there is much to suggest the need for another rescue package with additional money from the US Treasury if panic is to be avoided. Grabbing the headlines in the past week was Citigroup - once the largest bank in the world - which suffered the biggest ever one-day drop in its share price on Thursday on fears that current measures are not enough to stop the downward spiral. A solution for the US auto industry, which is fast running out of money, is also much needed if some sort of calm is to return to the markets.
Euroland: Weak PMI to be reflected in sharp fall in Ifo
PMI for Euroland again surprised negatively, as our below-consensus estimate proved all too positive, unfortunately. We had expected composite PMI to fall to 42.2, but the actual outcome was 39.2. Euroland is now in a deep recession that will stretch very far into 2009. Meanwhile, the significant falls in commodity prices will bring inflation considerably below the ECB target of close to but below 2% in the medium term. Given the above, we have revised our ECB forecast, now expecting that the ECB will cut its policy rate by 75bp in December and by a further 50bp in January 2009. In both February and March, we expect the ECB to cut by another 25bp, bringing the key rate down to 1.50% by the end of Q1.
The German Ifo index, which is due on Monday, will reflect the weak PMI numbers - we expect a fall to 87.0 from 90.2 in October. This would be the lowest level since 1993, and would signal - just like PMI - that Germany will again experience a drop in GDP in Q4, for the third quarter in a row. The fall will be driven by a further decline in the assessment of the current economic situation from 99.9 to 96.5, which would be the lowest since September 2005. The expectations index is also anticipated to drop further to 80.5 from 81.4 in October. This would mark a new low-point for expectations since German re-unification in 1990.
Inflation has fallen sharply in recent months, and we believe this tend will intensify in November. We expect Friday's flash inflation number will show a decline from 3.2% y/y in October to 2.4% y/y in November. This is a greater fall than consensus expects (2.5%), but given the recent tumble in oil and food prices, there is in fact a chance that the fall will be somewhat greater than we anticipate. In light of the pronounced movements in commodity prices seen in recent weeks and months, there is great uncertainty regarding the impact on consumer prices. A foretaste of the impact will be provided by Wednesday's inflation numbers for Germany. In any case, the recent falls in commodity prices highlight the need for the ECB to revise down its inflation estimate for 2009 in its upcoming forecast.
Among the other important economic data in the coming week, we would mention M3, which we expect will ease further in the wake of the financial crisis. Unemployment figures for Germany are due on Thursday.
Key events of the week ahead
- Monday: German Ifo. We expect a fall to 87.0 from 90.2 in October. Expectations index expected to fall from 81.4 to 80.5.
- Friday: Flash HICP expected to show a fall from 3.2% y/y in October to 2.4% in November.
- German national accounts and unemployment plus M3 for Euroland during the week.
Switzerland: SNB cuts to 1.00% from 2.00%
The Swiss National Bank (SNB) cut its interest rate on Thursday by one percentage point to 1.00%. Hence, the target range for the 3M LIBOR is now 0.50-1.50%. The cut came between the planned quarterly meetings, but after the 3M LIBOR fixed on Tuesday below the SNB target - for the first time since September. This latest move means the SNB has now cut its policy rate by 1.75pp in the past one and a half months.
In the accompanying press statement, the SNB said the cut resulted from the inflation outlook having improved significantly while the prospects for growth had deteriorated - not least due to lower global economic activity. Inflation is now expected to fall below the 2% target before the current year-end on the back of the recent falls in food and energy prices. At the same time, the economic data have generally been weak, and a number of the leading Swiss economic research institutions now expect an actual recession in Switzerland and average real GDP growth of below or just around zero in 2009. The latest sharp rate cut indicates that the SNB has probably also calculated on a recession or at least something close to recession in their economic growth forecast.
Looking ahead, we see a not insignificant chance that the SNB will ease monetary policy further, though focus will initially - as was also the case with the previous cuts - be on ensuring that the 3M LIBOR fixes at the SNB target. While the SNB has been particularly successful in the past month at bringing the 3M LIBOR down, this will presumably prove considerably more difficult going forward. In order to bring the 3M LIBOR down to target, the SNB has provided extremely generous short-term liquidity by, for instance, keeping the 1-week repo rate at just 0.5% since 7 November, and the Bank will have to continue providing extensive short-term liquidity if it is to reach its new target. This may prove difficult, however, as there is a natural limit as to how much lower short-term rates can be set and, furthermore, a high spread can still be observed in global money markets.
Key events of the week ahead
- Tuesday 10.00: Consumption indicator for October.
- Thursday 09.15: Employment for Q3.
- Thursday 17.00: SNB's Roth speaks in Bern.
- Thursday: Extraordinary AGM for UBS shareholders.
- Friday 11.30: KOF leading indicator for November.
USA: Spectre of deflation moves closer
The prospect of a significant downturn in global economic growth has prompted sharp falls in commodity prices, which are now feeding through into consumer prices. The October inflation numbers published in the past week showed a fall of 1.0 % m/m, the largest monthly decline ever, driven by a large drop in energy prices. More interestingly, though, core inflation, ie, consumer prices net of food and energy, also declined, down by 0.1% on the month. Deflation does not occur in an economy just because the price of a single group of goods, such as energy, declines. For deflation to be present, the price of a broad selection of goods needs to decline. In other words, core inflation and inflation expectations have to come down too. Although we expect inflation to continue declining in 2009, we do not expect to see a sustained period of deflation. That said, the concern about deflation is understandable, since the economic consequences of a deflationary environment are very negative. As falling prices increase the cost of debt, households and businesses will have an incentive to reduce debt levels, which in turn will weigh on consumer and corporate spending. Saving, on the other hand, becomes more attractive in a deflationary environment, and businesses and consumers will be tempted to put off investment or purchases of consumer goods. Hence, we could end up in a deflationary-recessionary spiral, which historically has proven difficult to stop.
However, the FOMC of the Federal Reserve and, not least, Bernanke are no doubt conscious of this risk. This concern has been one of the drivers of the massive liquidity injections into money markets and was reflected in the minutes of the October 28-29 policy meeting of the FOMC released in the past week. All committee members agreed that developments in the financial markets and the growth outlook were a cause of major concern, and the minutes indicated growing concern about deflation among FOMC members. Hence, there is nothing to indicate that the Fed will stay on hold, and we expect it to cut rates by another 50bp at the December policy meeting. This would take the effective fed funds rate down to close on zero. But this does not mean the Fed is running out of ammo, but rather that the central bank will use other instruments, such as quantitative easing of monetary policy, to counter any further deterioration in the growth outlook and hence avoid inflation running significantly below the Fed's comfort zone.
Key events of the week ahead
- Monday: Existing home sales set to continue trending down; look for a fall of 1.1% to 5.12 million.
- Tuesday: First revision of Q3 GDP numbers expected to show downward revision to -0.6 % q/q AR from -0.3%.
- Tuesday: We expect the Conference Board's consumer confidence indicator to rise to 40. However, the most important part will be the sub-section relating to the job situation.
- Wednesday: We expect income to have increased by 0.2%, while personal spending probably declined by 1.2% in October.
- Wednesday: New home sales set to come out weak. We expect a fall of 5.2% in October to 440K.
Asia: Japan now in recession
In Asia, Japan will once again be in the limelight in the week ahead. The third-quarter GDP data released during the past week officially sent Japan into recession - assuming that recession means two consecutive quarters of negative GDP growth (see Flash Comment - Japan: It will get worse before it gets better). On Thursday of the coming week the Bank of Japan will publish the minutes of the October 31 policy meeting, at which the BoJ cut its benchmark interest rate by 0.2 percentage points to 0.3%. Four committee members voted against the decision. Three of the no-voters favoured a larger rate hike, while one voted for unchanged rates. Hence, it will be interesting to get a clearer picture of the internal discussions at the BoJ, including not least the arguments for the view that money market rates too close to zero could hamper the functionality of money markets. Committee chairman Shirakawa in particular has lately argued along these lines. Based on inflation and growth developments alone, the BoJ could easily justify a return to a zero rate policy. As such, the likelihood of the BoJ resuming its zero rate policy depends, not least, on committee members' assessment of the costs of running zero interest rates. The minutes of the October 31 policy meeting will give us an idea about committee members' thoughts on this issue. The coming week will also see the release of consumer prices and industrial production data for Japan (due out Friday). The market has begun pricing in some likelihood of the benchmark Japanese interest rate being cut further. Twelve-month O/N forward is trading at around 0.25% at the moment.
Otherwise, the main focus in the week ahead will be on the release of Q3 GDP data for a number of Asian countries (India, the Philippines, Thailand and Malaysia). To nobody's surprise the Q3 GDP numbers reported so far have pointed towards weaker growth, and the preliminary data for Q4 suggest a significant slowdown in the last quarter of 2008.
Key events of the week ahead
- In Japan the minutes of the October 31 monetary policy meeting of the BoJ will be released Thursday. Consumer prices and industrial production data for October are due out Friday.
- No key releases expected for China in the coming week.
- Thailand (Monday), Philippines (Thursday), India (Friday) and Malaysia (Friday) are all set to publish Q3 GDP numbers.
Fixed Income: Deflation will be the next fear in line
The steep falls in yields in both Europe and the US continued unabated in the past week. The sour mood in the financial markets and the still swift and very synchronous deterioration of the economic numbers have further boosted expectations of rate cuts. The markets now expect that the policy rate will fall to 0.50% in the US by December and 1.75% in Euroland by next summer.
However, what is interesting is that the falls in yields in the past couple of days have not led to a steeper curve. On the contrary, 10-year yields have fallen more than 2-year yields. This has been particularly true in the US, and is due to an increasing expectation that it may be a long time before central banks again begin to raise rates. Underpinning the markets' expectation is a growing fear that the economic downturn could be so deep and long-lasting that the credit crisis might cause a deflationary spiral in the world's economies. That deflationary fears are not unfounded was confirmed in the minutes of the Fed's latest meeting, where several members mentioned deflation as a real risk (see Flash Comment - FOMC: Deflation fears looming).
In the US, where the policy rate is close to zero, making it difficult for short rates to fall further, growing deflation fears will primarily push down yields at the long end of the curve. In other words, a flatter US yield curve is increasingly likely if expectations grow of the fed funds rate remaining low for an extended period. Pulling in the other direction is the massive budget deficit, which has to be financed via the government debt market. Concerns about the increasing issuance of government bonds have so far been the prime reason why 10-year yields have had difficulty in falling further. However, it now seems that fears of deflation have begun to negate issuance worries.
The week ahead will see minor activity data in the US. In Europe, the German Ifo will be released along with final GDP numbers. We are not looking for any major positive surprises, meaning the downward momentum in the fixed income market will be maintained.
Danske Bank http://www.danskebank.com/danskeresearch
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