Sunday, February 21, 2010

Weekly Focus: Fed Takes First Steps Towards Exit

Market Movers ahead
  • Fed chairman Ben Bernanke will deliver the semi-annual monetary policy report (Humphrey-Hawkins) providing further thoughts on the economy and Fed exit.
  • The German ifo will provide more information on the strength of the German recovery where recent weak production data has spread concern.
  • Developments in Greece will continue to be on the market's radar screen as well.
  • The Danish government is expected to put forward the convergence programme on the public finances.
  • First set of hard data in Sweden for January should make a new step upwards. In Norway unemployment data will be scrutinised after the Q4 GDP disappointment.
Global Update
  • Risk appetite returned slightly in the past week as the Greek debt issue is losing attention. Equity markets recovered a bit while US bond yields pushed higher.
  • The Fed took the first step in its exit plan by raising the discount rate. Strong US industrial data shows the short-term strength of the recovery is intact
  • Asia's strong finish to 2009 was witnessed by better-than-expected Japanese GDP data for Q4.
  • In the first focus article we look closely at the outlook for the Swedish Riksbank. We see a 50-50 chance of a first hike in July followed by a further hike in October.
  • In the second article we elaborate on the outlook for ECB policy. Debt uncertainties and weaker data means it will be longer before the ECB dares to lift its foot off the gas pedal.

Market movers ahead

In the US the main event next week will be Fed chairman Bernanke's semi-annual monetary policy report before the House, the so-called Humphrey Hawkins. In a testimony last week, Bernanke laid out the contours of Fed's exit strategy and he will likely spend time on this issue next week as well. Especially any comments on the unwinding of the Fed's balance sheet will be worth watching after the FOMC minutes released this week revealed that some committee members favour starting gradual asset sales “in the near future”. The data calendar is dominated by the remaining regional PMI releases, home sales data and consumer confidence.
The German Ifo expectations index is projected to decline slightly next Tuesday according to our Ifo model. This would be the first decline in 14 months. We are particularly eager to see whether the manufacturing sector's expectations about production activity and exports will continue upwards. This would give some comfort following the surprising absence of German GDP growth in Q4 2009. The current conditions index is expected to increase.
German GDP details for Q4 will be published next week. We expect to see further declines in private consumption and investments countered by a boost from net exports. It will be interesting to see how much inventory changes contributed to growth in Q4. In Q3 inventory changes added 1.5%-point to German GDP growth, which indicates that Germany got the full benefit of the boost from the inventory cycle in Q3. If we see a negative contribution from inventories in Q4 it might well be that we will see revisions in the GDP figures and that the actual growth path has been smoother than the preliminary GDP data indicate. The German Bundesbank said Thursday that the slowdown in German recovery is only temporary.

Euroland new manufacturing orders are estimated to show a 0.6% m/m decline in December on Wednesday following the 2.7% m/m increase in November. The German unemployment rate is projected to remain unchanged at 8.2% on Thursday. German unemployment is kept artificially low because of the “Kurzarbeit” labour sharing scheme.

ECB releases data on monetary developments in January on Thursday. We look for a further pick-up in lending to households and a bottom in lending to non-financial corporations. M3 growth is projected to increase slightly from -0.2% y/y to -0.1% y/y while M1 growth is forecast to decline sharply from 12.3% m/m to 9.7% m/m due to base effects.

Not a lot on the agenda in Asia. Japan releases PMI data for February. PMI looks like it is topping out and production plans also suggest that the industrial recovery will slow down a bit in coming quarters as the inventory cycle will contribute less to growth. Trade data in Japan for January are expected to show continued decent growth in exports. Due to base effects the y/y increase will be very strong. Consensus looks for a rise of 40% y/y.

Global update

Risk appetite returns
This week we got further evidence that risk appetite has returned. Stock prices regained a notable part of their January decline, Greece is finally moving away from the stock markets' radar screen and risks of a double-dip recession appear to be receding in both the US and Asia.

The Eurogroup and Ecofin Council meetings on Monday and Tuesday provided little news on Greece and the next date of interest is now 16 March when the Commission evaluates Greek progress on implementation. The Greek use of currency swaps to lower the official debt back in 2001 still attracts some attention.

Focus has moved to the positive US macro data and the Fed. The Fed delivered several hawkish signals this week with the FOMC minutes showing that FOMC members are discussing asset sales and on Thursday the Fed raised the discount rate.

Developments in the Euro area have been more downbeat and there is an emerging risk that the Euro area will fall behind the global recovery. The ECB has become more dovish due in part to the Greek crisis and disappointing growth developments. This week we postponed the first ECB hike from August to November. Due to US strength and eurozone weakness, EUR/USD fell - especially after the Fed hiked the discount rate.
The Fed discusses asset sales and hikes the discount rate
Focus has been on the Fed this week. The FOMC minutes released Wednesday reiterated that an increase in the discount rate is desirable soon. This was the final signal to markets as the Fed chose to raise the discount rate by 25bp to 75bp on Thursday in a move to normalise the spread to the fed funds rate. The spread was at 100bp before the crisis.
As stressed in the released statement, this is part of the removal of unconventional measures and should not be seen as a signal of a change in the Fed's monetary policy stance. That the announcement is done outside an FOMC meeting further strengthens the signal that this is not a monetary policy decision. Going forward, we look for the unwinding process to continue and expect the original discount rate spread of 100bp to be fully restored during the coming three to four months, but see no fed funds rate hikes before November this year. The next step is likely to be a change in the ‘extended period' language, which we expect to arrive during Q2 (see Fed normalizes discount rate spread and Research US: A roadmap for the Fed's exit).

Furthermore, the FOMC minutes revealed an interesting discussion about the appropriate exit strategies. While there were diverging views, most committee members favoured reducing the amount of excess reserves before beginning a rate hike cycle. More interestingly, FOMC members expressed a range of views about asset sales. Most members agreed that a future programme of gradual asset sales could be helpful in reducing the Fed's balance sheet. There were, however, differing views on the timing of such asset sales. It seems that the majority favours waiting until the recovery is sustained and rate hikes have begun. However, “several thought it important to begin a programme of asset sales in the near future”. It thus seem as if the FOMC is longer in its exit thinking than we previously thought.

The week also delivered a round of comforting economic data from the US. Manufacturing production gained 0.9% m/m in January and production thus held momentum in the first month of 2010. At the current level, the ISM production sub index suggests that there is further upside to production growth in the coming months which was further supported by the increase in the Philly Fed index. Data on housing activity firmed as well with an increase in both single family housing starts and building permits. A sign of weakness was however found in the jobless claims which increased more than expected, suggesting that the improvement in labour market conditions has stalled. This is only one week's data, however, so it is too soon to draw any firm conclusions.
Greece moving away from the radar screen
The Ecofin Council did not provide many new insights on Greece at this week's meeting held on 16 February. The finance ministers emphasised that Greece now has to deliver. Aid measures are in the toolbox, but are not expected to be necessary and details have not been agreed upon. The IMF is to be used for technical assistance only. Greece has until 16 March to provide a timetable for implementing budgetary target measures involving a schedule with 4% of GDP tightening in 2010 and a deficit below 3% of GDP in 2012. By 15 May, Greece should outline policy measures needed to comply with the Council's decision. Quarterly reports should be submitted thereafter. In conclusion, Greece really has to mess this up before it ends up in a situation where nobody will help and it goes belly up. We are tempted to rule this out completely, but we just don't completely trust those Greek guys and their sense of reality.

On the data front, German ZEW and Euroland PMI were released this week. ZEW expectations fell less than feared and current conditions improved marginally - for more details please read Flash Comment - Euroland: ZEW expectations drop but less than feared. The more important PMIs - released today - were a little more comforting. Euroland Manufacturing flash PMI increased from 52.4 to 54.1 in February thus beating expectations (consensus 52.6, Danske 52.7) while service PMI declined to 52.0 from 52.5 (consensus 52.5, Danske 52.6). Manufacturing PMI is now the highest level since August 2007. Composite new orders flat, but manufacturing new orders increased slightly and manufacturing new export orders increased strongly to the highest level since December 2006! This is very comforting as Euroland needs the export engine to get going. Inventories of finished goods increased slightly to 56.5 and the order-inventory balance is thus coming down, indicating that the pull from the inventory cycle is slowing down. With the inventory engine slowing down, but the export engine still at full speed, there is still hope that we will see a recovery in private demand materialise before fiscal tightening kicks in.
A strong finish from Japan in 2009
According to Japanese GDP data, the economy gained momentum towards the end of 2009 again after stalling in Q3. GDP grew 1.1% q/q in Q4 which was slightly more than expected but Q3 was revised lower to 0.0% q/q from previously announced 0.3% q/q. The growth was mostly driven by exports but private consumption also showed decent growth. The Japanese Finance minister Naoto Kan stated in a response that the “risks of a double-dip recession are receding”. The Bank of Japan meeting this week was a nonevent with no changes in rates or asset purchases.
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