Sunday, January 23, 2011

Weekly Focus: Fear that Inflation Will Derail Recovery

*Market Movers ahead*
* We do not expect any major changes in the Fed statement in
connection with next week's FOMC meeting, despite the fact that
the annual rotation of voting members has meant a shift in a more
hawkish direction.
* In the eurozone the focus will mainly be on the release of flash
manufacturing PMI for January. This week's ZEW suggests that PMI
will continue to improve.
* We expect Norges Bank to keep its key policy rate unchanged at the
first monetary meeting headed by the new governor Øystein Olsen.
We expect no new framework for the conduct of monetary policy with
Olsen in charge.

*Global update*
* Inflation is in focus around the world and there are increasing
fears that central banks could be forced into pre-emptive strikes
that would possibly derail the fragile recovery.
* EU finance ministers discussed expansion of EFSF's mandate at this
week's Eurogroup and Ecofin, but no agreement was reached.
* In China GDP growth accelerated in Q4 10 fuelling fears that China
could be forced to tighten monetary policy aggressively.

* In this week's focus article we look closer at the new offshore
market for the Chinese currency that has started to develop in
Hong Kong and the opportunities it offers corporations and

The FOMC meeting will be the main event in the US next week. The
annual rotation of voting members in the FOMC has meant a shift in a
more hawkish direction (see Research US: FOMC rotation and monetary
policy outlook). Despite this fact, we do not expect much change to
the FOMC statement. In particular, we think the Fed will leave its
purchase programme unchanged.

All of the new hawkish voters in the FOMC (Plosser president of the
Federal Reserve Bank of Philadelphia, Fisher of Dallas, and
Kocherlakota of Minneapolis) have given speeches over the past two
weeks. Although they remain sceptical about the benefits of the Fed's
asset purchase programme, they have signalled that, so far, they aim
to stick with Chairman Bernanke's plan to buy USD600bn in treasury

The upshot is that with the 'überhawk' Hoenig of Kansas City, who has
continuously dissented over the past year, rotating off the FOMC as a
voter, we could go from a situation with one dissenter, to unanimity
in the 26 January FOMC statement. At the same time, economic
developments since the 14 December meeting do not give much reason to
change the statement language. The improvement in the labour market
has continued, albeit at a gradual pace, and in spite of GDP growth
running close to 4% q/q AR in Q4 last year, it will take some
considerable time to get the unemployment rate back at levels
consistent with the NAIRU.

Besides the FOMC meeting, we will get the first estimate of Q4 GDP
growth. We expect the economy to have grown at close to 4% q/q AR in
the past quarter driven by equally strong growth in personal spending.
Further, next week will provide an update on the housing market with
both house price data and home sales, followed by consumer confidence
data, a new round of regional PMIs and information on business capex
from the durable goods orders report.

In Euroland we have quite a busy calendar for the coming week. The
main releases are Monday's PMI figures for January and new industrial
orders for November. We anticipate the upbeat sentiment will continue
and expect PMI to increase further despite the current high level as
also this week's ZEW figures indicated. The renewed focus on inflation
in the eurozone will draw more attention than usual to the German CPI
release on Thursday. In the past week, ECB Governing Council members
have tried to fine-tune market expectations about future rate hikes.
The doves, represented by Ewald Nowotny, argued this week that
President Trichet's comments about inflation concerns at the last ECB
meeting perhaps had been "interpreted in a rather one-sided way". We
expect this fine-tuning to continue in the week to come when several
members of the ECB's executive board will be giving talks around

Until we get more clarification regarding additional help mechanisms,
focus will continue to be on new messages from Germany. So far,
Germany has tried to dampen expectations for a quick fix, saying that
we should not expect a solution prior to the European Council meeting
in March. Perhaps this can help buy German politicians some time to
convince the public that an enlargement of the existing measures is
needed. The main challenge is the headwind the German politicians face
in trying to turn the opposition which characterises the public
opinion in Germany. We do not expect a solution here and now, but
strong negative signals could cause spreads to widen again.

Two things are of particular interest in the UK next week: Q4 GDP
numbers and the Bank of England Minutes. UK data has surprised on the
upside recently in general and we think the economy expanded further
in late 2010. The pace is however set to have slowed compared with Q3
and that is even before the government's austerity measures have
kicked in. For Q4, we project a 0.4% rise on the quarter and +2.5% on
the year. It will be interesting to see whether more hawks have
emerged after CPI hit 3.7% in December - the highest in eight months.
We think it unlikely that any members have changed their minds ahead
of the Inflation Report next month and look for a 8-1 result with
Andrew Sentance as the solitary hawk. Markets could be disappointed at
such an outcome which could lead to a lower SONIA curve and higher

In Japan, the message from the Bank of Japan (BoJ) monetary meeting
next week is expected to be status quo. Hence, it will continue its
asset purchase programme but at this stage it is unlikely to be
expanded further. While GDP is poised to contract in Q4 10, recent
economic data suggests that the Japanese economy bottomed out in
November and GDP will return to positive growth in Q1 11. In addition,
the JPY has stabilised on the back of higher bond yields in Europe and
the US and hence appreciation pressure is no longer an argument for
expanding quantitative easing further. While inflation has increased
recently in line with developments in the rest of the world, inflation
in Japan is increasing from deflationary territory and hence, unlike
in Europe and the US, there will be no speculation that a rate hike
could be on the cards this year. Next week Japan will release foreign
trade data, inflation, retail sales and unemployment and this data is
expected to confirm that the Japanese economy bottomed out in

No major releases are planned in China next week.
*Fear that inflation could derail the recovery*
Concern is rising that increasing inflation around the globe could
temporarily derail the global recovery. Recent flooding in countries
like Australia, Brazil and India is currently putting additional
upward pressure on prices for agricultural and other commodities,
which creates increasing upside risk to our inflation forecast. In
particular in emerging markets, where the impact on inflation from
higher food prices will be largest, there is a risk that growth could
lose momentum. Not only will central banks be forced to tighten
monetary policy, but also the direct impact on demand through lower
real income growth will be larger. In addition, higher food prices
could entail considerable political risks, as the shown by the latest
developments in Tunisia.

With financial markets increasingly focusing on the possibility that
higher inflation could derail the recovery, the usual close
correlation between bond yields and the stock market has weakened over
the past week, with bond yields increasing despite a drop in the stock
market. EUR is also benefitting because ECB is more likely to respond
to an increase in headline inflation than Fed.

*Euroland: no agreement on extending aid mechanisms*
The main focus this week was on the Eurogroup and the Ecofin meetings
on Monday and Tuesday. Different extensions of existing mechanisms
have been discussed in the media but no agreement has been reached. An
expansion of the EFSF's mandate in order to give it power to buy
sovereign bonds in the secondary market, a reduction in the interest
rate charged to Greece, Ireland and other countries in need of
financial support, and an increase of lending facilities have been
mentioned. We expect the speculation on the future of the EFSF to
continue in the weeks to come.

The renewed focus on inflation continued this week. However, it
appears that the doves among the ECB's Governing Council members
wanted to counterweigh Jean-Claude Trichet's inflation concern
expressed last week. Ewald Novotny said "We do not see a need for an
interest rate change in the foreseeable future". Furthermore he added
"I think the statements of President Trichet at the last press
conference have been perhaps interpreted in a rather one-sided way".
The usual "super-hawk", Axel Weber, softened his tone as he said that
while inflation risks "could increase," they are still "more or less
balanced". He expects inflation to stay below the ECB's target in the
medium term. In the previous week, he said risks to the medium-term
inflation outlook "could well move to the upside.". This change in
Weber's position is interesting since he is still the most likely to
take over the position as ECB president in the autumn. We interpret
the mixed messages as the members trying to fine-tune the markets'

The German ZEW indicator for January came out at 15.4. This is
substantially higher than the figure of 4.3 for December and slightly
higher than consensus expectations of 7.0. Our expectation was a
figure of 11.5. This indicates a more positive sentiment and supports
the general view that Germany will continue to lead the growth in the

*Upbeat data in the US*
In general this week's run of data has been upbeat. First, initial
jobless claims fell back to close to 400,000 after the spike in the
first week of the year. This reassures us that the increase in claims
after the holiday weeks was a sign of a temporary processing backlog
rather than an underlying trend.

Second, housing data surprised on the upside. Existing home sales
jumped 12.3% m/m in December and although the level of overall sales
remains low, it may suggest that super strong affordability is finally
starting to revive home demand.

On the other hand, housing starts were weak, showing a drop of 4.3%
m/m in December, but much of this slowdown can likely be attributed to
terrible winter weather in much of the country in December. Building
permits improved markedly, up 16.7%, which suggests that starts should
pick up again in January. Some of the increase is however likely
driven by a rush by builders to apply for approval before new building
codes come into force in 2011.

Finally, the regional PMIs received so far have been strong. Both the
Philly Fed index and the Empire index showed improving new orders and
in ISM-adjusted terms, both point to an unchanged high reading of the
January ISM.

*Strong growth fuels concern about overheating in China*
In China GDP growth accelerated more than expected in Q4 10, but there
were signs of softness in the economic data released for December over
the past week, see Flash Comment - China: Growth accelerates, but
December data weak. According to our own calculations GDP growth
accelerated to 9.8% q/q AR in Q4 10 from just 7.5% q/q AR and hence it
appears that China's GDP growth again exceeds what is sustainable in
the long run. This fuelled the concern about overheating and possible
aggressive monetary tightening in China despite a decline in inflation
to 4.6%% y/y in December from 5.1% y/y in the previous month. That the
financial markets ignore the decline in inflation can easily be
justified as it will most likely prove temporary; inflation could well
increase above 5% y/y in January ahead of the Chinese New Year
celebrations in early February. However, there were signs of softness
in December with both investment demand and house sales declining and
it should be remembered that both China's manufacturing PMIs declined
in December. While we still expect growth to accelerate further in Q1
11, this suggests it might accelerate less than we currently expect.
Obviously further monetary tightening is on the cards, with the next
rate hike likely in late February or early March. However, it is the
pace of the credit growth in early 2011 that will be decisive for
growth in H1 2010, not the number and timing of interest rate hikes.

President Hu Jintao's state visit as expected brought very little news
on China's exchange rate policy. Predictably China stepped up the pace
of appreciation of its currency ahead of the summit and President
Obama - just as predictably - urged China to increase the appreciation
pace without getting any commitments from president Hu. However, it
should be remembered that CNY has appreciated by more than 3.5%,
suggesting an annual appreciation pace exceeding 6%. With substantial
inflationary pressure in China this appreciation pace will probably be
maintained and it should be enough to satisfy the US administration.

Source: ActionForex.Com

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