Sunday, February 15, 2009

Weekly Focus: Protectionism Back on the Agenda

There will be a lot to talk about at this weekend's G7 meeting. Obviously, the financial crisis and how to handle it will be an important theme. However, another pressing issue has emerged recently: Growing signs of protectionism. The US stimulus package, for instance, includes a ‘Buy American' provision requiring that only US materials be used in construction projects funded by the bill. The Buy American clause has been heavily criticised by both the EU and Japan, so the bill has now been softened. It now states that the US will not violate international trade agreements, including WTO and NAFTA rules. How this will be carried into practice is still uncertain, though.

In Europe, France in particular seems to be cultivating its own interests, with a EUR6bn car industry bailout that requires French companies benefiting from the package to stay in France for at least five years. In a dispute with the Czech Republic, French President Sarkozy said that he would encourage French companies - for example, in the Czech Republic - to move their operations back to France. Naturally, this met with heavy protests from the Czech Republic, and the EU has asked for further information on the planned bailout for French carmakers.

Although protectionism is always looming when the world economy is in a crisis, until recently protectionist pressures were largely contained. Recent developments are ominous, though, underlining how important it is for the G7 to take control of the situation very soon. Waging a trade war would simply obstruct a solution to the global economic crisis and be much like scoring a huge own goal - witness the Great Depression of the 1930s, when protectionism just made matters worse.

Euroland: ECB to reach 1% by the summer

Due to a softer rhetoric from the ECB lately and the more downbeat outlook for the Euroland economy we have revised down our forecast for ECB rates (See Flash Comment - Euroland: ECB expected to reach 1% by Summer). We now see the end point at 1.0% rather than 1.5%. We continue to look for a 50bp easing at the March meeting but now expect the ECB to ease by a further 25bp in April and 25bp in June. Why not cut all the way to zero? We believe the expected improvement in PMIs globally will lead the ECB to stop cutting rates when we reach the summer. By then, PMIs should have risen for five to six months and more positive signs in the US are likely to have evolved. This will put the ECB on the sidelines to wait for the stimulus to work.

During the week the ECB's Weber - one of the arch-hawks - gave an interesting speech. He said that "We should not at this point avoid to lower rates aggressively, because we understand at the current juncture all indicators look like the economy is in freefall.” (See Flash Comment - Euroland: Weber confirms shift in ECB focus). The ECB seems to have set aside its aversion to cutting rates to a very low level. That the economy is in freefall was clearly confirmed by Q4 GDP data this week. German GDP fell a whopping 2.1% q/q - weaker than the consensus expectation of -1.8%. Euroland GDP as a whole fell 1.5% q/q. Highlighting the woes for the auto industry in Europe, numbers showed that car sales in Western Europe fell 26.9% y/y in January.

Softer rhetoric from the ECB and weak data has added downward pressure to Euroland yields. Helping in this direction was also the aggressive rate cut from the Riksbank of 100bp and a very dovish Bank of England pointing to zero rates before long (see UK). EUR/USD has traded broadly sideways over the past week at around 129 but we expect it to resume the move lower over the coming months.

Key events of the week ahead

  • Tuesday: ZEW likely to rise further and signal gradual improvement in surveys in general.
  • Friday: Flash PMI should recover further in February as the pace of decline in activity tapers off. It will still signal very weak growth, though.

Switzerland: Banks in the spotlight

In Switzerland, the past week has been all about the banks' annual results. Tuesday saw the country's biggest bank, UBS, release miserable results, with total losses for 2008 of CHF19.7bn, and on Wednesday its second-largest bank, Credit Suisse, published losses for the year of CHF8.2bn. While writedowns and losses in the financial sector do not in themselves affect growth in Switzerland, these results do illustrate the difficult environment for financial companies, and we expect the financial sector to continue to make a negative contribution to growth in Switzerland. The sector contributed up to half of overall Swiss economic growth in 2005-07, but throughout last year it practically cut the country's growth in half. Both banks also announced plans for redundancies: Credit Suisse said that it would be cutting 5,300 jobs, and UBS announced a further 2,000 job losses. Despite the big financial package in the autumn and the successful recapitalisation of the banks, UBS in particular has remained one of the hardest-hit global banks, and the financial sector is still - thanks to a large share of the economy by international standards - a significant risk factor for both growth and the CHF.

The week also brought important inflation data. There was a surprisingly big drop in CPI inflation from 0.7% in December to just 0.1% in January. As elsewhere in the world, the slide in commodity prices played a major role in this, with oil products alone contributing a drop of 1.3pp relative to last year. Prices of foreign manufactured goods also fell by 3.8% y/y, pulling down inflation by 1.1pp, which would support the argument that the slowdown in global demand has pushed down prices. But with inflation well below the 2% target and there being a risk of a lengthy period of falling prices, the pressure is on the SNB to ease monetary policy further, although the bank is continuing to maintain that the recent big drops in prices are only temporary.

We have published a new interest and exchange rate forecast today (Friday). Our forecast for the SNB's interest rate target is unchanged - we expect this to stay at 0.50% for the rest of the year. However, we think it likely that the SNB will lower the upper end of the band for the 3M LIBOR. We also expect the bank to use alternative instruments to ease monetary policy (such as purchases of corporate and/or government bonds), and have therefore revised down slightly our yield forecast for longer maturities. We have not changed our forecast for the CHF.

Key events of the week ahead

  • Tuesday, 09.15 CET: December retail sales. The series is usually rather volatile, but it will still be interesting to see how Christmas trading was affected.
  • Thursday, 08.15 CET: January trade balance.
  • Thursday, 11.00 CET: ZEW expectations.

UK: Bank of England to follow in Fed footsteps and introduce ZIRP

The Inflation Report this week from the Bank of England (BoE) pointed to further clear downside for interest rates. The BoE painted a very bleak picture of the British economy and paved the way for further easing. The most striking feature in the Inflation Report was the BoE's forecast of inflation. The BoE expects inflation to be only around 1% in the medium term based on current market rates and estimate that the economy will still have a lot of excess capacity on this horizon. This means that even if the BoE cuts rates to zero it would not be enough to push the medium-term inflation rate up to the target of 2%. This is a clear signal that the BoE will indeed cut rates as low as possible - zero - and probably introduce quantitative easing. We can therefore expect the BoE to start buying credit assets without financing this with short T-bills - and hence print money to buy credit assets. This is similar to what the Fed is doing in the US mortgage market, where it buys mortgage-backed securities without funding it with treasuries.

Based on the Inflation Report we now expect the BoE to cut rates to zero in two steps - a 50bp cut in March and a further 50bp cut in April. There is also the possibility that it will cut by the entire 100bp in March. Whether it goes all the way to zero - or as the Fed uses a range of 0-25bp - is not clear. It might choose to have a slight positive interest rate due to technical issues surrounding money market funds.

The minutes from the latest BoE meeting will be released next week and might give more insight into the BoE's thinking. Otherwise focus turns to data for CPI and retail sales. In the past week we saw a little light in terms of the BRC retail sales monitor, which showed a slight improvement. It may be that the stimulus from lower rates and rapid decline in commodity prices is starting to have a stabilising effect. The level of growth is still very low, though, and hence pressure to give more help is still in place.

Key events of the week ahead

  • Monday: Rightmove house price index could rise m/m as indicated by the HBOS number last week.
  • Tuesday: CPI likely to show further decline in inflation.
  • Wednesday: BoE minutes (see above). CBI industrial survey to stay weak.
  • Friday: Retail sales might improve as signalled by BRC.

USA: Obama's financial rescue plan leaves many questions unanswered

Stateside, the week was all about fiscal policy. Congress managed to agree on a fiscal policy stimulus package running to USD789bn, equivalent to around 6% of GDP. Thus the overall package is only marginally smaller than the original USD819bn proposal from the House of Representatives.

Centre stage, though, was Treasury Secretary Timothy Geithner's unveiling of Barack Obama's rescue plan for the financial sector. The overall impression of the plan is that it leaves more questions unanswered than one might have hoped (see Research US: A united rescue effort, but short on detail). There had been a great deal of speculation about the creation of a federal ‘bad bank' that could take over the toxic assets that are creating uncertainty about banks' solvency, but the new Financial Stability Plan does not provide for a fully government-financed bad bank. Instead there will be a public-private investment fund which will buy up toxic assets for which there is otherwise no market. There are no clear answers yet as to how the fund is to attract private investors, how the risk associated with its assets will be shared, or how prices will be set. All larger banks will also be subjected to a stress test to see whether they have sufficient capital to withstand future losses. Banks that have undergone this stress test will then be eligible for a federal capital injection.

Taken as a whole, the rescue plan will probably remove much of the uncertainty about individual banks' state of health. But with so few details in place and an extensive stress test to be completed first, the plan will take time to implement. The most interesting incoming data in the coming week are consumer prices for January. We expect the overall CPI to be unchanged from December, with core inflation at 0.2% m/m. The minutes of the FOMC meeting on 27-28 January are due to be released on Wednesday, and it will be interesting to see how much the FOMC members discussed buying up treasuries. The week also brings a number of speeches by FOMC members, the most important coming from Ben Bernanke on Wednesday.

Key events of the week ahead

  • Tuesday: We expect the NAHB housing index to drop to 7.
  • Wednesday: Minutes of the January FOMC meeting, a speech from Ben Bernanke, and data for housing starts, building permits and industrial production in January.
  • Thursday: We expect producer prices to climb 0.3% m/m overall and 0.2% m/m ex. food and energy.
  • Friday: We expect the consumer prices to be unchanged from December and core inflation at 0.2% m/m

Asia: Japanese growth to plummet in Q4

In Japan, the big event of the week is the release of GDP figures for Q4 08. We expect GDP to contract by no less than 2.5% q/q. It is primarily exports that dragged the economy down during the quarter. Our calculations indicate that exports fell by 12% q/q, with the result that net exports knocked a whole 2.0pp off growth from Q3 to Q4. This massive drop in exports has hit both business investment and the labour market, and so the GDP figures will be weak across the board. We expect private consumption and business investment to fall by 0.9% q/q and 2.5% q/q, respectively. The greatest uncertainty is associated with stocks. We expect stockbuilding to boost GDP growth by 0.3pp q/q, but the figure may well turn out to be higher. This heavy stockbuilding in Q4 means that the growth outlook for Q1 this year is also weak. We currently anticipate further contraction of 0.8% q/q, but we hope to see some stabilisation of activity during Q2.

We expect the BoJ to keep its leading rate unchanged at 0.1% at the monetary policy meeting on Wednesday and Thursday. Anything else would be an enormous surprise. The bank has signalled clearly that it does not want to take its leading rate right down to zero, as this would jeopardise the functioning of the money markets. Interest will therefore centre on any new unorthodox easing. The BoJ has already announced plans to buy financial institutions' commercial paper and shares, and it is possible that the bank will announce concrete plans to buy corporate bonds in connection with the monetary policy meeting. However, it is important to stress that the main problem in Japan is not the banks' inability or unwillingness to lend. The country's weak growth is due primarily to a huge external demand shock. This means that the weak fiscal policy reaction and political uncertainty are ultimately a bigger problem at the moment than the financial sector's woes.

In China, no important news is expected in the week ahead. Economic data are still painting the picture of an economy that has begun to stabilise at the beginning of this year. The rapid acceleration in credit growth from 18.7% in December to 21.3% y/y in January is another sign that the effects of more expansionary monetary and fiscal policy are beginning to feed through. Although inflation will probably remain negative during the spring, the pressure for aggressive easing of monetary policy is abating. We have therefore reduced the degree of monetary policy easing in our forecast for China, see Flash Comment - China: Inflation to temporarily enter deflationary territory.

Key events of the week ahead

  • In Japan, Monday brings GDP figures for Q4, while Thursday's monetary policy meeting at the BoJ is expected to result in an unchanged key rate of 0.1%.
  • No important data are expected out of China during the week.

Foreign Exchange: Zero Interest Rate Policy taking its toll on GBP and SEK

During the past month, two trends emerged in the FX market: broad based euro weakness - as the single currency lost against all G10 currencies, but the Swiss franc and the New Zealand dollar - and a very strong appreciation of Norwegian krone. Both movements were in line with our general forecasts, although the strong Norwegian krone rally came sooner than we had expected.

Another tendency has been a turnaround in global activity indicators, most noteworthy a recovery in PMIs, business surveys and shipping rates. Thus, it is natural to raise the question as to whether we have seen a trough in the global cycle. We believe that the evidence is indecisive. First, we have only seen one month of improvement. Second, we are still seeing an accelerating fall in employment, a collapse in global trade, and very weak final demand. Finally, one has to remember than even following a turnaround, global PMIs will still be at very low levels indicating a significant contraction. That said, we forecast a turnaround in activity indicators during H1 and expect the US ISM index to climb above the neutral 50 by year-end. This will be important for the currency market and should, all else being equal, support the pro-cyclical Australian dollar, New Zealand dollar and Canadian dollar against the defensive yen and Swiss franc, which is also factored in to our new forecast.

For some time, the sustainability of the US twin deficits and the possible future impact on the dollar has been a widely debated topic. However, recent data points to a marked improvement in the trade balance, raising the question about whether one leg of the twin deficit, the current account deficit, is in the process of self-resolving. The monthly US trade deficit has narrowed from around USD60bn late summer last year to just USD40bn in December. This suggests to us that the current account deficit could narrow to below 3% of GDP this year, which would be a significant improvement from the close to 6% peak a few years ago. With both lagged effects from past FX movements and the business cycle working for the US current account, this should be less of an issue going forward. Nevertheless, given the state of the US public finances, the currency risks of the other leg of the twin deficit remain in place. The approval of the Obama USD789bn economic stimulus plan will add more to this imbalance.

The convergence in world interest rates toward zero is continuing, most recently illustrated by both the Bank of England (BoE) and the Swedish Riksbank (RB). In its latest Inflation Report the BoE presented an inflation forecast undershooting the inflation target by one percentage point indicating a move toward Zero Interest Rate Policy (ZIRP) and potentially a vote in the MPC on quantitative easing. This sent sterling weaker and we expect further sterling depreciation in the months to come. In Sweden, the Riksbank slashed its policy rate to 1% and indicated further rate cuts. There now seems to be a fair chance of the Riksbank cutting rates to virtually zero and adopting unconventional methods of stimulating the economy. Also, the Riksbank indicated that the weakening krona would be welcomed in the current environment.

In our newest forecasts, we have thus pencilled in further Swedish krona and sterling weakness in the short term, while we expect further Norwegian krone strength against the euro. Turning to EUR/USD, we expect further dollar gains in the months to come, while we see limited potential for USD/JPY and EUR/CHF to move much lower.

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