Sunday, March 1, 2009

Weekly Focus: ECB Under Pressure - also from Inside

Key focus for the coming week will be the ECB meeting on Thursday. It looks set to be a very interesting meeting - not least after stories in the past week about mutiny within the ECB. The Daily Telegraph reported that a growing number of members were seeing the need for a more aggressive approach as economic and financial woes continue to mount. Industrial production is in freefall and survey data from Ifo and PMI fell back again in February after showing some improvement in January. Add to this increasing internal pressure as several countries see their bond yields rise significantly due to supply worries and speculation about potential EMU break-up. And to top off the problems the crisis in Central and Eastern Europe (CEE) has escalated recently. This will weigh further on Euroland growth as banks - particularly in Austria and Italy - could get a strong hit from losses in CEE (See Research Euroland - Exposure to the crisis in CEE). It is also a blow to especially German exports which are highly exposed to CEE.

Several ECB members have started to express the need to act fast. Italy's central bank governor Mario Draghi pointed to the experience from the US in the 1930s and Japan in the 1990s which suggested it was necessary to fight the crisis in the early phase. This was indeed a lesson from the Great Depression in the 1930s as we described in our recent Research Global - Lessons from the Great Depression. We expect ECB to cut rates by 50bp on Thursday and keep the door open for further easing on the back of sharply down-ward revised projections for both growth and inflation. It will be quizzed on quantitative easing but we do not think the ECB is ready to go down that path yet - both due to reluctance but also due to the practical prob-lems of implementing it in a currency union with 16 dif-ferent countries.

Euroland: Ifo index record low, but expectations are getting less negative

The German ifo index fell from 83.0 in January to 82.6 in February, reversing last month's increase. This is the lowest reading for the ifo since German unification in 1990. However, the decline was purely driven by a decline in the current conditions index, which tends to be the lagging part of ifo. The other part - the expec-tations index - rose for the second month in a row, confirming that some bottoming is taking place, albeit from very low levels. Overall the reading is not as bad as could have been feared, and slightly positive that expectations have risen further. But ifo is still at very low levels, pointing to an ongoing recession with espe-cially manufacturing in bad shape. Looking ahead we expect ifo to grind slowly higher over the coming year. The crisis will continue for a long time, though, and further action from the ECB is needed. We continue to look for a 50bp cut in March to 1.5% and further cuts by June to 1.0%.

Developments in Central and Eastern Europe have fuelled new concerns that some euro area banks will face substantial losses in the region. Losses on loans in CEE will be substantial due to an unfortunate mix of collapsing property prices, economic downturn and exchange rate depreciation. Austria is by far the most exposed country, but the government can afford to absorb the losses if neccesary. Belgium, which is a high debt country with a fiscal budget that's already stretched, is in for smaller losses, but they also have less room for manoeuvre. In scenarios ranging from a “mild” scenario, which is comparable to the Swedish bank-ing crisis, to an ugly scenario which is more comparable to the Asian crisis the Austrian banks face losses of 3½-11% of GDP, Swedish banks loose 2-6% of GDP and Belgian banks loose1-3½% of GDP.

Key events of the week ahead

  • Monday we get final Euroland PMI for February
  • Monday we also receive flash estimate for Euroland inflation in February
  • Thursday ECB is expected to cut the policy rate 50 basispoint to 1.5 %.
  • Thursday we also receive revised Euroland GDP fig-ures for Q4 2008.

Switzerland: Updated macro forecast

We published an updated macro forecast for Switzerland during the week. The most significant change from our previous forecast is that we now anticipate a marked decrease in output in 2009, giving an average growth rate of -0.8%. The weakness in Switzerland is very broad-based, but we expect investment in particular to drag down economic growth. As a delayed reaction to the sharp slump in aggregate demand, we have recently seen a deterioration in the labour market, with unemployment climbing 0.3pp in the past three months. Developments in the financial sector in particular give us cause for concern in terms of future developments in the labour market.

There is no doubt that the Swiss economy is in recession, but how long it lasts will depend on a number of factors. As Switzerland is a small open economy with the bulk of the export sector (around 60%) focusing on the Western European market, the duration of the recession in Euroland in particular will be a key factor for when Switzerland escapes the current downturn. One positive factor for the Swiss economy, though, is its strong starting position. Switzerland entered the current recession with very high growth rates by historical standards and a tight labour market with low unemployment and high employment. Furthermore, unlike most larger economies, Switzerland has not had any great house price bubble, and the Swiss economy has generally had few imbalances. However, since the global recession kicked in, Swiss growth has slowed as sharply as that in Euroland, with Switzerland's very large financial sector in particular making a negative contribution to the overall economy. Uncertainty about the financial sector is the main reason why we still consider the risks to Swiss GDP to be on the downside.

The Swiss government has taken various steps to stimulate the economy. These include bringing forward public expenditure to the beginning of 2009, and releasing CHF 550m for job creation schemes, with a further CHF 650m to follow during the spring. A third fiscal policy package is also on the cards. By international standards, though, these measures are relatively modest, as together they amount to just 0.3% of GDP.

Key events of the week ahead

  • Monday, 19.30 CET: SNB chairman Jean-Pierre Roth speaks in Frankfurt.
  • Tuesday, 07.45 CET: Q4 GDP release. We expect negative growth for the first time since 2004.
  • Thursday, 14.30 CET: Finance minister Hans-Rudolf Merz speaks in Geneva on the country's bank se-crecy laws.
  • Friday, 09.15 CET: Inflation figures for February. There is a risk of a decrease in prices y/y.

UK: Waiting for quantitative easing

Key focus for the coming week will be the meeting at the Bank of England (BoE) at which we expect it to deliver a cut of 50bp to 0.5%. We think BoE is likely to stop at 0.5% because taking rates lower could put pressure on banks' affordability as it could force some banks to narrow the spread between deposit rates and lending rates. However, as we wrote in Weekly Focus last week, BoE has made it clear that it sees it necessary to embark upon quantitative easing in order to get inflation back towards the target in the medium term. At the last meeting “the Committee unanimously agreed that the Governor should write on its behalf to the Chancellor to seek authority to conduct purchases of government and other securities, financed by the creation of central bank money…”. We are not sure of the timing of this but it may be that BoE will defer the final decision to start quantitative easing until the meeting on Thursday. Either way, BoE is likely to start soon and the more interesting question is how big an amount it will use to purchase and what bonds it will purchase. We believe BoE will prefer to buy credit bonds as this will have a more direct impact on the economy. Buying government bonds does put more money in the economy but it cannot be sure where that money will end up and how much impact it will have on the economy.

On the data front the past week offered a few interesting numbers. The distributive trades survey on retail sales saw a rebound from -47 in January to -25 in February, confirming the picture of some bottoming in retail sales which has been seen both in the BRC retail monitor and the actual retail sales. The level is still weak, though, and the sharp rise in unemployment will continue to weigh on consumers. In the housing market, data from Nationwide showed another strong decline in February of 1.8% m/m, throwing some cold water on the tentative signs of bottoming in prices seen in the house prices from Halifax and Rightmove. The coming month's data will be interesting to see which data are painting the truest picture.

In the FX market EUR/GBP has been range trading around 0.885 this week. We expect to see a slightly higher EUR/GBP in the coming months as BoE embarks on quantitative easing. GBP is undervalued, though, and we expect it to strengthen again in the longer run. In the bond market, we have witnessed some upward pressure on yields - mostly driven by rising yields globally on the back of more supply focus as US have had heavy supply this week. We expect to see bond yields range trading for a while but after the recent rise we believe there is value in the short end of the UK bond market.

Key events of the week ahead

  • Monday: We expect PMI manufacturing to slip back a bit after the rebound in January as has been seen in Euroland
  • Wednesday: PMI services - same picture as for manufacturing
  • Thursday: BoE meeting (see above)

USA: Still shell-shocked

The past week has confirmed that parts of the US economy are still suffering from shell shock. The Conference Board consumer confidence index hit a record low in February, home sales slumped to new lows in January, durable goods orders in January dropped to 2004 levels, and the tentative signs of recovery in several of the local business activity indices in January have been eroded. Federal Reserve chairman Ben Bernanke's testimony in Congress also re-flected this bleak outlook when he said that there were significant negative risks to the Fed's main scenario of a re-turn to positive growth in H2 unless markets start to recover soon. On monetary policy, he indicated that interest rates will stay close to zero for some time, and that quantitative easing will continue for as long as is necessary to get the economy back on track. However, there were no specific indications of what the Fed's next move might be (see Flash Comment - FOMC: No news from Bernanke).

Unfortunately there is little prospect of encouragement in the coming week, which brings two of the most important indicators for the US economy: the ISM survey and the employment report. In line with our expectation of a general improvement in industrial indicators in H1, the ISM index rallied in January. However, several of the local indices have indicated a fresh deterioration in February. There is therefore a risk of a fall in the ISM manufacturing index in Febru-ary. However, the local indices are not always “ahead” of the national ISM index - sometimes the reverse is true. Tak-ing account of the underlying improvements that we now believe to be feeding through to the index, we predict only a small drop in the ISM from 35.6 to 35.0. This level is still consistent with marked negative growth rates in the econ-omy in Q1. We still expect the index to recover to around 45-50 by mid-year (see Research US: Manufacturing re-covery ahead). Given the deeply negative growth in the economy, the labour market is under immense pressure cur-rently. This picture is likely to be reflected in the employment report for February, where we expect a decrease in em-ployment of no less than 650,000 people and an increase in the unemployment rate from 7.6% to 7.9%. In other words, there are as yet no signs of a stabilisation in the labour market, and so there is a risk of unemployment climb-ing higher than our current forecast of 9% early next year.

Key events of the week ahead

  • Monday: We expect the ISM manufacturing index to fall from 35.6 to 35.0 in February.
  • Tuesday: February auto sales.
  • Wednesday: We expect the ISM service index to fall from 42.9 to 42.5 in February.
  • Wednesday: Beige Book from the Federal Reserve.
  • Friday: We expect the employment report to show a drop in employment of 650,000 people and a rise in unemployment from 7.6% to 7.9%.

Asia: Sharper focus on stimulating private consumption in China

In China, the annual National People's Congress (NPC) kicks off on Thursday and is due to run until 18 March. The NPC is the country's parliament and nominally the highest political body in China, as it must approve all important legislation. In reality, though, the NPC does not have any real independent political power, as nominations are closely controlled by the ruling Communist Party. That said, the annual sessions have become more interesting in recent years, partly because the discussion of proposed legislation has become more open, and partly because they are now also being used by the Chinese administration to announce its key economic policy goals.

In his report to the NPC, prime minister Wen Jiabao will probably stick to the established 8% target for GDP growth, although this will undoubtedly be very difficult to achieve in 2009. It has already been announced that a budget deficit of at least 3% of GDP is expected this year, which stands in stark contrast to the surplus of more than 0.5% of GDP in 2008. The expected deterioration in public finances is, of course, a result of the marked easing of fiscal policy currently being undertaken in China. The NPC's agenda will reflect the growing shift in the focus of fiscal policy easing towards stimulating private consumption rather than being very one-sidedly about public investment. This will primarily take the form of a number of laws bringing about an historic expansion of the social security system. First and foremost, almost all Chinese will have access to a social insurance scheme which provides access to sickness, unemployment and health insurance. The scheme will be financed by contributions from employers and employees together with public subsidies mainly for low-income groups. These laws are not scheduled to enter into force until 2010, but this is a very substantial expansion of the social security system in China and may help to reduce Chinese households' very high savings and get them spending. There is also the possibility of the NPC discussing reductions in income tax (higher basic allowances) and a stimulus package for the housing market.

Otherwise the big event of the coming week is the publication of industrial activity indicators. It will be exciting to see whether the more positive trend of recent months can be sustained, not least in the light of the disappointing provisional PMIs in Europe and regional ISM indices in the US. However, China is the country where the signs of stabilisation are most robust, and we expect this to be reflected in the coming week's PMIs.

Key events of the week ahead

  • In China, the focus will be on the publication of the CLSA PMI on Monday and the NBS PMI on Wednes-day. The annual National People's Congress opens on Thursday.
  • In Japan, figures for car sales are released on Mon-day and investment data on Friday. The latter are an important input for the first revision of Q4 GDP.

Foreign Exchange: Central banks centre stage

A number of central bank meetings and important releases of economic data make for a particularly event-ful week ahead. The following looks at the possible FX implications of the week's interest rate decisions, starting with the Reserve Bank of Australia (RBA) in the early hours of Tuesday and the Bank of Canada (BoC) later the same day, and concluding with the Bank of England (BoE) and the European Central Bank (ECB) on Thursday.

In Australia, recent data suggest that economic contraction may yet be avoided in Q4, although no signifi-cant positive growth can be expected. This means that the RBA's interest rate decision is associated with considerable uncertainty, with a risk of the leading rate being left unchanged at 3.25% (the consensus ex-pectation is a 25bp cut, while the money market is pricing in a cut of 25-50bp). This in turn spells uncer-tainty about the AUD, and an unchanged interest rate would probably lead to a rise in the AUD/USD. Given the current environment of high risk aversion and low commodity prices, we are nevertheless reluctant to recommend long positions in the AUD/USD, although it might be worth considering going long on the AUD/NZD.

In Canada, it is now plain to see how the deep recession across the border in the USA is impacting on the country's economy. There has been sharp deterioration in key economic data (unemployment, retail sales, home and car sales, trade balance - the list goes on), and the growth outlook is weak. It therefore seems likely that the BoC will be looking to further stimulate the economy on Tuesday. A 25bp rate cut to 0.75% is the consensus in the market, but a bigger cut can definitely not be ruled out. It should be noted, however, that the USD/CAD has been trading in the interval 1.20-1.26 for some time despite the downturn in the Canadian economy and the general lack of risk appetite. Although we see a chance of some CAD weakening following the interest rate decision, the upside potential in the USD/CAD may be limited. In the longer term, as risk appetite and commodity prices presumably recover, we can see potential in both the AUD and the CAD against the USD.

In the UK, the BoE indicated implicitly in the minutes of its February meeting that 0.5% is the limit for how low the bank rate can go. We therefore agree with the consensus that the BoE will cut by 50bp to 0.5% on Thursday. The outlook for the UK economy remains bleak: domestic demand is weak, and there is a major risk of inflation undershooting the BoE's target. There is therefore a clear need for further stimulation, and quantitative easing can be expected. BoE governor Mervyn King said during the week that the BoE believes money supply growth to be too weak. The BoE has previously proved willing to take drastic action, and we cannot rule out the possibility of the bank's interest rate decision being accompanied by details of further expansion of its balance sheet, which could surprise the market. This presents a downside risk to the GBP, despite its already weak level. By long-term valuation measures, though, the GBP is deeply undervalued, and there should be potential for a correction in the longer term, especially against the EUR.

In Euroland, we reckon that the ECB will cut its leading rate by 50bp to 1.5% on Thursday, which is in line with the consensus. Although ECB governor Jean-Claude Trichet has not ruled out the use of unconven-tional measures to stimulate the economy, we do not anticipate any indications of a shift to quantitative easing in the immediate future. However, in the light of recent disappointing data, including the 1.5% de-crease in GDP in Q4, we do expect a substantial downward revision of the ECB's growth and inflation pro-jections, which are published together with the interest rate decision. Any indications of further rate cuts could put pressure on the EUR.

We reckon that the risk in EUR/GBP in connection with these interest rate decisions is primarily on the up-side. That said, the EUR has run into more of a headwind in the past couple of weeks, due partly to uncer-tainty about the economic and financial situation in Central and Eastern Europe and the sharp economic contraction in Euroland. We therefore think it is better to position for possible GBP weakening by going short against the USD.

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