Weekly Focus: "Unorthodox Situation Requires Unorthodox Response"

The above remark was made by Fed Chairman Ben Bernanke recently as a comment to the current crisis. Bernanke is a leading expert on the Great Depression and has written several papers on how the breakdown of credit intermediation was an important reason that the Great Depression became so protracted. Policymakers responded in an orthodox manner with fiscal policy focused on balanced budgets and a monetary policy focused on defending the dollar. He also highlights that the Fed was misled in judging monetary policy by only looking at the nominal rate to judge the looseness of monetary policy. At that time, deflation became widespread and hence real rates were not low. And credit intermediation broke down completely. Hence, overall financial conditions were far from loose even though nominal rates were low.

This is also very much the case today, which is why the Fed is so aggressive and starting to use unorthodox measures. In Euroland, rates have also been lowered more than usual, but tighter lending standards and a substantial widening of credit spreads mean that overall financial conditions are not loose at all. Hence, in our view, there is need for more stimuli in terms of lower rates from the ECB. This was highlighted this week which saw more extremely weak data for Euroland (see Euroland).

We think a very long recession can be avoided but it requires that the policy response is significant - to match the size of the shock - and comes early.

Unfortunately the ECB is already starting to show reluctance to ease policy much further. The meeting next week will be an important guide of how great this reluctance is. We expect a cut of 50bp, taking the leading rate to 2.0%. But there is a risk that the ECB passes this time.

Euroland: ECB to cut rates

Things have been relatively quiet since Christmas. The final PMI data for December saw the composite index lowered a tenth of a point to 38.2, a new record low, due to the downward revision of the index for the manufacturing sector from the flash estimate of 34.5 to 33.9, also a record low. These figures correspond to a further decrease in GDP of 0.6% m/m in Q4 after a drop of 0.2% q/q in Q3. This is making its mark on unemployment, which is rising. It has even begun to climb in Germany, edging up from 7.5% to 7.6%. In itself, an increase of 18,000 in the number of jobless in Germany is not particularly worrying. What is worrying, though, is that unemployment is set to climb relatively quickly in the coming months as businesses adjust production to weak demand and bulging stocks. German industrial orders fell by 6.0% m/m in November, or 24% y/y.

Meanwhile inflation is falling rapidly, due primarily to low energy prices. Headline inflation slowed from 2.1% y/y in November to 1.6% y/y in December, and producer prices fell by 1.9% m/m. Thus inflationary pressures are receding rapidly.

Pressure on the ECB to deliver a substantial rate cut at its meeting during the week is therefore mounting. We expect the bank to cut its leading rate by 50bp, but there is a significant risk of the ECB disappointing us here. The bank has stated repeatedly that it has already cut rates faster than ever before, and that the cuts so far of 175bp have yet to be fully transmitted to the economy.

Otherwise the week looks relatively quiet, with just final inflation figures for Germany and Euroland in December. We expect these to confirm the flash estimates. In other words, we expect headline inflation of 1.1% y/y in Germany and 1.6% y/y in Euroland, and core inflation in Euroland of 1.8%.

Key events of the week ahead

• Thursday: ECB rate-setting meeting. We expect the leading rate to be cut by 50bp.
• Thursday: Final inflation figures for Germany and Euroland in December. We expect these to confirm headline inflation of 1.1% y/y in Germany and 1.6% y/y in Euroland, and core inflation in Euroland of 1.8% y/y.

UK: Bank of England 'only' cuts by 50bp

The Bank of England (BoE) has cut rates further by 50bp to 1.5% in the past week. This puts the cumulative rate cut over the past three months at 350bp. The fact that it 'only' cut by 50bp (in line with our and consensus expectations) suggests that it is not quite as close to a Zero Interest Rate Policy as some have been speculating. Hence, rates rose slightly and the GBP strengthened after the announcement. Among other things, the BoE points to an unusually sharp and synchronised downturn in the world economy (see BoE statement). Surveys of retailers and reports from the bank's regional agents also point to weaker consumer spending. Interestingly, they also point to the need for further measures to increase the flow of lending to the nonfinancial sector as credit has been tightened further (as witnessed in the recent credit conditions survey). The substantial weakening of the GBP is mentioned specifically as the Bank of England says that "the substantial depreciation in sterling over recent months may help to moderate the impact on UK net exports of the slowdown in global growth". The weak GBP is probably a reason for the bank not to be even more aggressive. Still BoE saw a "significant risk of undershooting the 2% inflation target in the medium term", which suggests more is in the pipeline and we expect a further 50bp cut in February and unchanged thereafter. The risk is for more rather than less easing, though, as the recession will likely continue through most of 2009 with rapidly increasing unemployment. The bond market prices around 60bp of further easing from BoE over the next six months, which seems about fair to slightly cheap in our view. We expect the pound be fragile near term due to the outlook of low rates, weak economic prospects for the UK and the bleak outlook for London's important financial sector. A key variable is also the performance of the equity market. The longer-term outlook is much brighter for the undervalued sterling. We will update our EUR/GBP forecast in the next edition of FX Forecast Update (due to be published on 15 January).

The data in the past week have confirmed the risk of a prolonged slowdown as house prices declined by a further 2.5% in December. This led to an annual decline of 15.9%. Consumer confidence also fell further and is at the lows seen during the recessions in the early 1990s and the first oil crisis in the early 1970s. PMI data saw some stabilisation in December, though, but are at very low levels

Key events of the week ahead

• Tuesday: RICS house price survey has risen recently and some sub components point to stabilisation in house prices on a six-month horizon. It sounds too good to be true and it will be interesting to see the development in December. DCLG house prices also released.

USA: Bleak midwinter data - but consumer spending could surprise

Incoming data over Christmas and New Year have changed little about the picture of a US economy deep in one of its fiercest post-war recessions. Industry has really stamped on the brakes over the last 3-4 months in response to a lethal combination of a collapse in demand growth and an acute shortage of liquidity. The liquidity problems in particular may have accelerated the downturn in many economic data by forcing businesses to cancel investments, run down stocks and fire staff more quickly than during a "normal" economic downturn. As things stand, there is the prospect of negative GDP growth of around 5% AR in Q4, making it the worst quarter since the recessions of the 1980s. And we expect further - albeit milder - contraction in Q1 this year.

While data from the business sector have been almost unfathomably poor, there has been a slight ray of light from the household sector. The steep fall in energy prices and extraordinarily low sale prices in the run-up to Christmas have given a historically strong boost to households' real purchasing power. This meant that - despite the credit crisis, declining wealth and rising unemployment - there was scope for a healthy increase in real personal consumption of 0.6% m/m in November. The coming week brings retail sales data for December, and there is the prospect of another sharp fall. However, as in November, the expected drop of 1.1% m/m will be down to lower prices. Assuming a drop in consumer prices (due out on Friday) of 0.9% m/m, there will be another healthy increase in real personal consumption in December, probably on a par with November. The result is a much smaller decrease in personal consumption in Q4 (1-2% q/q AR) than generally anticipated even just a month ago. The December figures will also provide a good starting point for Q1 and so a real chance of positive growth in personal consumption right from the start of the year. This would be a pleasant surprise - including for industry. Mere stabilisation of consumer spending in the coming quarters would be enough to inspire a substantial improvement in business confidence over the spring and summer.

Key events of the week ahead

• Wednesday: Retail sales are expected to fall by 1.1% m/m, but due to lower prices rather than a decline in real spending.
• Wednesday: The Fed's Beige Book will provide a status report on the economy from the central bank's network.
• Thursday: Producer prices will fall 1.5% m/m, pulled down by plummeting energy prices.
• Friday: Consumer prices will fall by 0.9% m/m.
• Numerous speeches from FOMC members.

Asia: Industrial activity collapsed at the end of 2008

The latest data from Asia suggest an extraordinarily large and rapid drop in industrial production in Q4. In Japan, for example, industrial production fell by no less than 8.1% m/m in November, which is the biggest monthly drop ever (see Flash Comment - Japan: Sharpest-ever drop in industrial activity). Even so, sales are still falling faster than production, and stocks are unsustainably high, as can be seen from the chart below. There is therefore the prospect of industrial activity in Japan continuing to plummet in the coming months. Japanese industrial activity figures are published together with plans for industrial production over the next two months, and these plans tend to be quite a good indicator of industrial activity. According to these plans, activity will slide further by just over 8% m/m in December. If this holds, industrial production will have fallen by a whopping 18% in Q4!

Unfortunately this picture is not unique in Asia. Export- and manufacturing-based economies like South Korea and Taiwan have seen similarly sharp drops in exports and industrial production. A raft of Asian countries will therefore see negative GDP growth in Q4 2008 and probably also in Q1 2009. As for Japan, we now estimate that GDP fell by around 1.5% q/q, pulled down by a sharp downturn in exports and business investment.

The highlight of the week in Asia is the release of Chinese trade data for December. In the light of movements for exports in South Korea and Taiwan, we predict a further fall in exports of around 4% m/m, corresponding to a decrease of almost 12% y/y. This big drop in exports would suggest a sharp slowdown in growth in Q4 2007. We now estimate that GDP growth slowed from 9.0% y/y in Q3 to 7.0% y/y in Q4, and the risk is that it may have slowed even further.

Key events of the week ahead

• In Japan, current account data for December are released on Tuesday and machine orders for November on Thursday.
• In China, trade data for December are expected at the beginning of the week. It is also worth keeping an eye out for money supply and credit growth figures for December

Foreign Exchange: Looking into the crystal ball

How will a shift in global economic conditions affect FX markets? What will be the likely implications of a sharp recovery in stock markets and how likely is an equity rally? What will it take for carry trades to come back into fashion and will 2009 be a great carry year? Will credit risk conditions normalise and how will this affect FX markets? Are the major central banks likely to intervene in one or several major currency crosses in 2009 and at what levels would they possibly do so? We are facing a flurry of questions, and the answers are not straightforward. Nonetheless, in the past week, we have ventured a guess at things to watch in the new year.

• The OECD's leading indicator was an important gauge in 2008: The indicator continuously signalled an economic slowdown (indicator below 100 and falling), suggesting that AUD, CAD and GBP would face headwinds, while JPY, CHF and EUR looked likely to strengthen. This proved a good strategy (+24 % pa including carry in 2008). However, if the leading indicator turns around, FX markets will make a U-turn, and the currencies that previously lost out will probably strengthen and vice versa. Is this likely to happen? Almost definitely: the OECD's indicator has been designed to lead the business cycle by six months, so the most offensive currencies might soon begin to gain ground.
• All else being equal, an increase in the MSCI World index to 1200 would have the greatest effect on the dollar crosses; USD/JPY would probably rise towards 101 (about +6% from implied level) and AUD/USD towards 0.78 (+7%), while the largest impact would be seen in NZD/USD, which could rise towards 0.66 (+8%). An equity rally would probably halt the strengthening of the Swiss franc and could see EUR/CHF rise to 1.57 (+2%). The Scandinavian currencies would no doubt benefit; however, as they have already weakened too much relative to what should be expected in an equity downturn, it is no use trying to estimate their exact rate levels. A fall in EUR/NOK and, not least, EUR/SEK of 3-5% should definitely not be ruled out, though.
• Credit conditions will probably not deteriorate any further in 2009, and a modest improvement is not unrealistic. A narrowing of credit spreads would have more or less the same effect on FX markets as an equity rally. Hence, it would cause a weakening of JPY and CHF and a strengthening of SEK, NOK, AUD and NZD. That said, FX markets are less correlated with credit markets than with equity markets, making it more difficult to quantify the effect of narrower credit spreads.
• 2009 is not likely to be a great carry year - the expected interest rate gain is too modest and FX uncertainty too large for that. We do not expect carry trades to become attractive until we see a substantial increase in carry-to-risk indices - and that is not just around the corner. Carry-to-risk for EUR/CHF, currently at just under 0.2, would probably have to rise above 0.4, as it did during the happy days for speculative currency traders in 2006-07. For two other popular carry trades, AUD/JPY and NZD/JPY, the thresholds for investor interest have usually been higher. Hence, for these trades, carry-to-risk measures (currently as low as 0.2 and 0.25, respectively,) would probably have to rise to 0.5-0.6 before providing an attractive basis for interest rate arbitrage.
• The failure of central banks to intervene in the major currency crosses in 2008 in spite of extreme movements does not mean that there will be no intervention this year. We will probably see some sabre-rattling from the major central banks and they might start buying or selling their own currencies actively if USD/JPY drops below 85, EUR/USD below 0.80 and EUR/CHF below 1.45 or if EUR/GBP increases significantly above 1.00.

In addition to the events and triggers discussed here, we believe it will be important to look at the development in debt issues, as many countries are troubled by large budget deficits that are likely to grow further this year. That said, the close link between equity prices and exchange rates will continue to dominate in the short term.

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