Sunday, March 7, 2010

Weekly Focus : ECB Struck a Dovish Tone

Market Movers ahead
  • In the US the main event is the February retail sales data. The past couple of months have been strong. However, February data is set to look bleaker as snow storms probably had a negative impact.
  • In Euroland the focus is on manufacturing production numbers. These data are likely to attract great attention as the December production numbers, especially out of Germany, were quite dismal being below the September level.
  • In Scandinavia the focus of attention also turns to inflation. Headline inflation is expected to be pushed higher both in Norway and Sweden due to higher energy prices.
Global Update
  • Risk appetite returned and the euro stabilised this week as the markets greeted the announcement that Greece will implement additional EUR4.8bn austerity measures.
  • The ECB signalled that it would proceed very cautiously with its monetary policy exit. According to the ECB the weekly main refinancing operations and the onemonth auctions will continue to be with full allotment at least until 12 October 2010.
  • US manufacturing ISM disappointed to the downside. It edged lower to 56.5 from its recent peak of 58.4 indicating some slowdown in the pace of manufacturing growth, but from robust levels.
  • In the first focus article we give a brief overview of the commodity market and we discuss why commodities have been able to defy the latest dollar strengthening.
  • In the second focus article we use the US bond market in 2003-04 as a case study to evaluate the potential market impact of a change in Fed rhetoric.

Market movers ahead

In the US, next week's main event is the February retail sales data. Over the past three to four months, there have been encouraging signs of recovery in consumer spending. However, February data is set to look more bleak as snow storms probably had a negative impact. We estimate a 0.1% m/m decline in retail sales ex. gasoline. On top of this, a decline in gasoline prices will depress the headline further through a negative effect on the nominal data. Hence, total retail sales are expected to decline by 0.3% m/m. Even so, real personal spending is tracking 2.5% q/q AR growth in Q1.
Elsewhere, focus will be on NFIB small business optimism for March and weekly claims data. A speech by New York Fed's Dudley mid-week could prove interesting ahead of next the FOMC meeting on 16 March.
January manufacturing production data are due to be released across Euro area member states next week. These data are likely to attract immense attention as the December production numbers, especially out of Germany, were quite dismal coming out below the September level. Industrial production was otherwise on a strong upward trend from April to September 2009, but weak December data fuelled fears that growth in the Euro area is losing momentum before labour markets stabilise and private spending picks up.
This scenario is of deep concern to us, but is however not our baseline case. Forwardlooking expectation surveys still point upwards. Manufacturing surveys (PMIs) show that new orders are still advancing, and this is particularly valid for new export orders due to a re-acceleration in Asian demand going into 2010. We take some comfort from these indicators, and we thus expect industrial activity to have advanced during January, especially in Germany where the export share to Asia is fairly high. Hopefully this should enable a near-term stabilisation of European labour markets, which are crucial for the European recovery.

In the UK, focus will be on data for industrial and manufacturing production, due Wednesday. The British economy is only recovering slowly and we do not expect the January numbers to cheer the market. Focus will probably also be on remarks from the BoE that held the base rate unchanged and refrained from extending the asset purchase target in the past week but nevertheless has made the market nervous for additional QE efforts. Finally is the upcoming election getting more exiting as there seems to be a risk of ‘hung parliament'. Sterling has been under pressure in recent weeks which most likely can continue for while still.

In China, this year's session of the National People's Congress (NPC) - China's main legislative body - started on 5 March and will be in session until 15 March. NPC has very little real power in China and for that reason is usually not the forum for major political decisions. However, the NPC session is an important tool for the Chinese government to communicate its policy for 2010, which has largely been agreed upon in closed door meetings since early December last year. A change in policy has of course already been apparent in recent months. So far the government has only signalled a very cautious exit from its very accommodative policy. While the government is trying to curb credit growth from 30% last year, its current 17% target for this year is still quite accommodative. In addition, the Chinese government is not planning a major reduction in public infrastructure spending this year, albeit focus will now be on finishing existing projects. Nonetheless, at the NPC, it should become even more apparent that the Chinese leadership is becoming more confident about growth and to a larger degree turning its attention to containing consumer and asset price inflation.
Most Chinese economic data for February will be released this week. Industrial production, retail sales and fixed asset investments data for January and February will be released at the same time. As usual, there is little visibility in Chinese data because of seasonal distortions from the Chinese new year holiday (in February this year, in January last year). We will pay particular attention to the inflation numbers, which we expect to accelerate sharply from 1.5% y/y in January to 2.7% y/y in February, partly because of the seasonal impact from the Chinese new year holiday. In Japan, GDP growth for Q4 09 will probably be revised down to 3.8% q/q AR from 4.6% q/q previously when the first revision is released on Thursday. This is due to weaker-thanexpected capex in a survey released last week, which is the most important new information in the first revision.

Global update

Risk appetite returns, but markets still in need of visibility
Risk appetite returned and the euro stabilised this week as the markets greeted the announcement that Greece will implement additional EUR4.8bn austerity measures. With signals that ECB will proceed very cautiously with its monetary policy exit, bond yields remain gridlocked as central banks are expected to continue to provide cheap funding for yet a while.

Economic news has been mixed lately - partly due to the bad weather in both Europe and US in February. The picture of a peak in growth momentum continues to materialise with global PMI looking toppish and other leading indicators losing speed. This supports our view of slowing but above trend growth during the first half of this year.

The combination of slowing growth and a gradual policy exit coupled with local debt problems continues to provide a challenging environment for investors. Risky asset markets and long bonds have been range trading over the past 3-4 months as investors remain uncertain about the sustainability of the recovery. Right now the markets need some visibility about the situation in Greece and the US job market to move more decisively in one direction.
US: Bad weather, good excuse?
The gyrations in US data have continued over the past week providing mixed signals about the current pace of growth. While some of the recent fluctuations have definitely been caused by the extreme weather situation on the east coast during February, there is little doubt that the pace of growth has slowed from the 5.9% q/q AR pace in Q4. That said, data generally indicate relatively robust growth rates of about 3% in Q1.

ISM data were among the data offering mixed signals. The manufacturing ISM edged lower to 56.5 from its recent peak of 58.4 indicating some slowdown in the pace of manufacturing growth, but from robust levels. While the ISM manufacturing index may have peaked, we believe that the index will hover in the high 50s for the remainder of H1. Indeed our models continue to suggest a fair level around 60. The real positive surprise however, was the increase in the non-manufacturing index to 53.0 from 50.5, which indicates that the recovery is finally broadening to the service sector.
While personal spending data for January was robust putting Q1 real consumption growth on track for 2.5%, vehicle sales for February drifted lower from an already depressed level. However, recent developments in compensation, unemployment, wealth and credit paint a somewhat brighter picture for US households and we are relatively confident that consumer spending will continue its moderate recovery.

In housing the bad news continues to flow. This week the pending home sales report printed another sharp drop in existing home sales - now down more than 20% from the October level. We now see a risk of mild contraction in residential construction during H1 and are concerned about a new leg up in prices due to low demand and huge supply from foreclosed homes.
ECB is heading towards the exit at a slow pace
The ECB general council meeting Thursday showed a dovish ECB that is moving slowly towards the exit. The ECB's weekly main refinancing operations and the 1-month auctions will continue to be with full allotment at least until 12 October 2010. That the ECB promised to give full allotment for such a long period was a surprise. For the 3- month auctions the ECB is now moving to fixed allotment. We expect that the ECB will move to fixed allotment at the 1-month auctions in October and for the main refinancing rates at end-2010 at the latest (most likely in October too). The ECB's assessment of the economic situation continues to become slightly more positive, but we do not expect an interest rate hike before November 2010 at the earliest.
The European Commission said on Thursday that measures taken by Greece to address its financial troubles are enough for 2010, but further measures will be needed in 2011 and 2012. EU Economic and Monetary Affairs Commissioner Olli Rehn also said that “the eurozone is ready if necessary to take coordinated measures to guarantee its stability”, "We have the resources to do so". It is our assessment that a rescue package involving German KfW buying Greek bonds is most likely ready to be implemented, but the Eurogroup is still hoping that Greece can handle this on their own. If Greece is rescued there is a moral hazard problem and the solution is probably closer fiscal monitoring and a stricter application of the rules.

Weak Chinese PMIs mainly seasonal distortions
China's two manufacturing PMIs both declined in February but it is premature to conclude that growth in China is slowing. Weakness was most pronounced in the official NBS manufacturing PMI, which in February plunged to 52.0 from 55.8 driven by sharp drops in new orders. However, the large drop in new orders was mainly driven by seasonal distortions due to the Chinese New Year holiday. India, South Korea and Taiwan today all reported very strong gains in their manufacturing PMIs in February, which is hardly consistent with a slowdown in China.
In Japan the unemployment rate in January unexpectedly dropped from 5.2% to 4.9% driven by strong gains in employment, confirming that unlike the US and Europe the labour market in Japan has already turned. In fact, the unemployment rate in Japan peaked at 5.6% as long ago as July last year. Despite the strong gains in employment in January, we still expect GDP growth to slow substantially to below 2.5% q/q AR in Q1 10. However, it appears that the improvement in the labour market will offset a large part of the negative impact from less fiscal stimulus and for that reason Japan is unlikely to end up in a double-dip recession. Nonetheless, deflation in Japan is easing slower than we expected. While headline inflation in January increased to -0.4% 3m AR underlying deflationary pressure appears to have increased further with consumer prices excluding food and energy declining 1.6% 3m AR. In addition, JPY has again strengthened significantly in effective terms in the past two months mainly because of the weak EUR. In fact, JPY in effective terms is as strong as in late 2009, when BoJ believed the strong JPY was a threat to the Japanese recovery. Hence, we cannot completely rule out the possibility that Bank of Japan (BoJ) will bug the global trend and ease further. If BoJ eases further it will most likely be bringing down money market interest rates with longer maturities by supplying liquidity at a fixed interest rate for longer maturities.
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