Weekly Focus: All the Best for 2009

2008 has indeed been an extraordinary year, with the most severe financial crisis since the Depression in the 1930s. The concept of a pure investment bank has almost ceased to exist in the US, and we have seen events no one had dared imagine - for example the bankruptcy of an investment bank - Lehman Brothers (founded in 1847). The repercussions of the Lehman default led to a near collapse of financial markets. The paralysis of the financial system has been a major blow to the world economy and led to the steepest economic downturn since WWII.

The rise in commodity prices during the first half of the year led to widespread inflation fears as prices reached 20-year highs around the world. Bond yields soared and we saw several central banks hiking rates to fight inflation (not least ECB and the Riksbank). The rise in inflation contributed to the collapse in consumption growth globally as it eroded purchasing power and as such plays a major role in the downturn we are witnessing now. In the second half of 2009 commodity prices u-turned and inflation fears turned into deflation fears within a few months. The substantial rise in bond yields reversed into significant declines. Government bond yields have now reached historical lows in both US and Euroland - at the same time credit bonds have seen the highest yield levels in decades.

So this is where we stand now - at the brink of a new year with the global economy in recession and deflation fears widespread. 2009 will indeed be a difficult year also. But we are cautiously optimistic that equity and credit markets will recover and that the combination of massive policy stimulus and a marked decline in commodity prices will take us slowly away from the abyss - starting in the US during spring 2009 and followed by Asia in H2. Unfortunately Euroland - and Denmark - will likely have more adjustments to deal with before recovering in 2010.

Euroland: Winding down for Christmas - except at the ECB

The Euroland PMI surprised on the upside during the week. The composite index did fall to a new record-low of 38.3 from 38.9 in November, but this was slightly better than expected: the consensus estimate was 37.8. It was primarily the service sector index that exceeded expectations, with a modest decrease from 42.5 to 42.0 (consensus 41.2), while the manufacturing index dropped from 35.6 to 34.5 (consensus 34.3). That said, both hit new record lows. Meanwhile the German Ifo index dropped from 85.8 to 82.6, which was further than expected (consensus 84.0, Danske Bank 83.5). However, it was encouraging that the expectations index, which is a good indicator of output three months ahead, fell quite modestly from 77.6 to 76.8, which was less than expected (consensus 76.6, Danske Bank 76) and suggests that we are close to bottom.

The big question is whether these "soft" indicators are sufficiently bad for the ECB to lower its leading rate as far as we expect at its meeting on 15 January. We predict a 50bp cut. The signals from members of the ECB's governing council are mixed: the hawks are saying that "the remaining room for manoeuvre is very limited" following the recent 175bp interest rate decrease, while the doves are saying openly that "rapidly falling inflation expectations, and in some areas deflation risks, together with the impossibility of lowering rates below zero, pose the most challenging test for the effectiveness of monetary policy" (Mario Draghi on 16 December). There was already disagreement on the governing council at the meeting on 4 December, with Jean-Claude Trichet saying at the press conference that there was a "consensus" to decrease the leading rate by 75bp, whereas he normally talks of a "unanimous" decision. Trichet himself, who typically sits about midway between the two camps, is now talking of a need to "concentrate on getting what we have already decided operational" - in other words, getting the 175bp interest rate decrease to impact on the real economy - consumers and businesses. The ECB has announced a normalisation of the relationship between the so-called deposit rate and the rate on the marginal lending facility and the policy rate (which is currently 2.5 %) from 21 January. The aim is to encourage banks to lend to each other to a greater extent than at present (see Research Euroland: ECB reverses course and widens ratecorridor). Also being discussed is a clearing house to support the interbank lending market. The idea is to counter the lack of trust between banks by having the ECB guarantee loans.

Things are now winding down for Christmas on the release front, and there will be a relatively quiet start to the new year, with just the final PMI for the Euroland manufacturing sector on 2 January. Like the final PMI for the service sector due out on 6 January, this is expected to confirm the flash estimate. Also coming up are German factory orders and industrial production on 8 and 9 January respectively, as well as CPI data for the German provinces and retail sales for Germany and Euroland.

Key events of the week ahead

• 2 January: Final Euroland manufacturing PMI, expected to be unchanged from the flash estimate of 34.5.
• 6 January: Final Euroland services PMI, expected to be unchanged from the flash estimate of 42.0.
• 8 January: German factory orders.
• 9 January: German industrial production.
• CPI data for German provinces and retail sales for Germany and Euroland.

Switzerland: Continued downturn in Swiss economy, upturn in CHF

The CHF has strengthened considerably in the past week, thus breaking - at least temporarily - the downward trend that began at the end of October when the CHF/DKK peaked at 5.21. This has come despite an historic appreciation of the EUR (and so the DKK), which underlines the strength of the driving forces behind the CHF at the moment. Part of the explanation for this can be found in the Danish/Swiss policy rate spread beginning to close again after widening considerably since the end of October as the Swiss National Bank cut its policy rate target to the current 0.50%. However, we would also put much of the turnaround in the CHF/DKK down to growing uncertainty in the market, as reflected by a marked increase in volatility in the CHF/DKK cross. We expect the CHF to strengthen further and predict a CHF/DKK of 4.97 in 3M.

Upcoming releases will signal a continued deterioration in the Swiss economy. The KOF leading indicator published on 29 December is expected to drop from -0.05 to -0.25 in December, suggesting weak output through to the summer. CPI inflation is expected to drop from 1.5% y/y in November to 0.6% y/y, pulled down mainly by low energy prices, and all the indications are that this trend will continue through to the middle of next year. Weak economic activity is also making its mark on the labour market, with unemployment expected to climb from 2.7% (seasonally adjusted) to 2.8% in December.

Key events of the week ahead

• 29 December: We expect the KOF to continue to trend downwards, dropping to -0.25 in December.
• 8 January: We expect inflation to fall from 1.5% y/y in November to 0.6% y/y, and unemployment to climb from 2.7% (seasonally adjusted) to 2.8% in December

UK: Pound reaches new lows on speculation of Zero Interest Rate Policy (ZIRP)

The main event over the past week has been the ongoing plunge of GBP as it moved from 90 to 95 against the euro. The trade weighted GBP has fallen 4% this weak and is now down 25% from the peak a little over a year ago. The decline happened on the back of Fed's move to ZIRP and market speculation that Bank of England (BoE) may be going in the same direction. This view was fuelled further when Charlie Bean, BoE's deputy governor, said in an interview with the Financial Times published on Thursday that the deteriorating economic outlook could see UK interest rates falling close to zero.

The Bank of England and the Fed have proved to be the most aggressive central banks, while ECB is clearly more reluctant to take extraordinary measures. Hence as long as momentum is down for rates, the weakening pressure on the pound should persist. The comments also led to further sharp declines in UK bond yields with the 2y yield falling to 1.25%. Our central forecast is for BoE to deliver two more cuts of 50bp in January and February but the risk is rising that BoE could opt for another 100bp easing at the January 8 meeting.

Looking into next year we believe there are reasons to expect a recovery of the UK economy around the middle of 2009. The UK economy is in deep recession now but we should not underestimate the amount of stimulus that will arrive in 2009: the effect of massive rate cuts, the substantial weakening of the GBP, a rapid decline in commodity prices and finally fiscal stimulus will combine to provide a historical boost to the British economy. Hence at some point next year the tide in financial markets are likely to change and we should see the GBP strengthen and bond yields rebound. For that to happen, though, we probably have to see some sign that things are stabilising - most likely in the form of rising PMI's and also a turn in the US ISM, which might give hope that the US economy is also moving away from the abyss.

Key events of the week ahead

• The most interesting data over the coming weeks will be credit conditions survey and PMI on Friday 2 January. Look for further tightening of credit standards and a continued weak reading of PMI
• Markets will look ahead to the BoE meeting on 8 Jan where a cut of 100bp cannot be ruled out (our base scenario is 50bp cut)

USA: Zero interest rate policy

The Federal Reserve decided at its meeting on Tuesday to lower the fed funds rate to a target range of 0-0.25%, which is the closest we will get to a zero interest rate. But the message in the FOMC's statement was clear: although there is nothing more that can be done via policy rates, the potential for further easing of monetary policy is far from exhausted (see Flash Comment - USA: Fed pulls all the plugs).

In the statement, the Fed more or less committed itself to keep the fed funds rate "exceptionally low" for some time, and we expect it to leave it unchanged throughout 2009. With the monetary policy rate effectively out of play for many months to come, the focus now is on the alternative instruments that the Fed might use. So far it has largely fol lowed the script from Ben Bernanke's famous "helicopter speech" in 2002, and Tuesday's FOMC statement was no exception. Much of the statement was dedicated to outlining the measures that the Fed has already put into place, such as buying up MBSs and supporting the ABS market. Future quantitative easing of monetary policy may take the form of further purchases of MBSs and purchases of long-term Treasuries, but we also expect to see measures tar geting specific credit markets in difficulty.

The Fed has already had success in bringing long mortgage rates (Fannie Mae and Freddie Mac) down sharply, and we have seen the first signs of a wave of refinancing building up. The potential gains for US homeowners as a whole run to something like USD 100bn. There is also the prospect of marked fiscal policy easing in H1 2009, the latest indications being up around USD 850bn, primarily in the form of public investment in infrastructure. These aggressive moves by the US authorities, combined with the massive boost to real incomes from falling energy prices, will help to promote gradual recovery in the US economy during the course of 2009. However, we do not expect to see positive GDP growth before Q2 next year, and the upswing will be moderate by historical standards as falling house prices, rising unemployment and the downturn in the financial sector continue to put a damper on growth.

The most interesting data in the coming weeks will be ISM manufacturing and the December nonfarm payroll report. We expect a further fall in the ISM to 35.4 from 36.2, but a bottom is beginning to form. The labour market is being hit hard at the moment, and we expect yet another month with a steep fall in employment, with 481,000 jobs lost.

Key events of the week ahead

• 23 December: We expect a fall of 5.4% m/m in new home sale and a fall of 0.3% in existing home sales.
• 2 January: We expect a fall to 35.4 in ISM for the manufacturing sector.
• 6 January: We expect a rise to 38.5 in ISM for the service sector
• 9 January: Employment is still on a downtrend, and we expect a fall of 481,000 in nonfarm payrolls.

Asia: Bank of Japan makes final rate cut

The BoJ cut its policy rate by 20bp to 0.1% on Friday and left the rate it pays on banks' deposits unchanged at 0.1%. Thus a solid floor has been put under money market rates at 0.1%, and the BoJ no longer needs to worry about whether it will hit its target of an O/N rate of 0.1%. This means that the BoJ has given itself room to increase liquidity. Although BoJ governor Masaaki Shirakawa was unwilling to admit it at the press conference, this is in reality a step towards quantitative easing of monetary policy, very much like that announced by the Federal Reserve earlier in the week. No concrete targets have been announced for how far liquidity or the BoJ's balance sheet are to grow, but expansion of liquidity and the bank's balance sheet will be a consequence.

In connection with the monetary policy meeting, the BoJ announced that it will be raising its target for purchases of Japanese government bonds. It has also opened up the possibility of making direct purchases of commercial paper in the market, and further measures may be on the way. We do not yet have details on the extent of the bank's commercial paper purchases, but this is a clear signal that monetary policy in Japan will now increasingly be aimed directly at establishing vital credit flows in the economy. We do not expect the BoJ to lower its policy rate further - Shirakawa has argued vociferously that a zero interest rate could undermine the functioning of the money market.

Asian currencies have bounced back strongly in december in the wake of the slide in the USD (see chart below). Although we are still upbeat about Asian currencies a year ahead, when we expect the global economic climate to be more favourable, we are still urging caution in the short term. For one thing, growth is currently slowing sharply, and we will probably see policy rates in many Asian countries plunge to historically low levels. Although this will help to lay the foundations for stronger growth later in 2009, it will be bad news for the region's currencies in the short term. There is also the possibility that we will see a slightly stronger USD on the back of its recent sharp depreciation.

Key events of the week ahead

• In Japan, the minutes of the 21 November monetary policy meeting will be released on Christmas Day, while Boxing Day will bring figures for manufacturing output, consumer prices and unemployment in November and the manufacturing PMI for December.
• In China, the main focus will be on the publication of the manufacturing PMIs for December on New Year's Day (NBS) and 2 January (CLSA).

Foreign Exchange: Explaining the EUR/USD Christmas rally

Since the beginning of December, we have witnessed one of the sharpest EUR (DKK) appreciations against the USD ever recorded. As a result, EUR/USD (USD/DKK) is now trading at levels not seen since September. Except for relative interest rates, we cannot explain the recent move in EUR/USD in terms of the usual short-term drivers; we have seen neither a rebound in oil price nor a rally in equities during December. In the following we look at drivers which could explain the recent moves.

As interbank markets froze in the wake of the Lehman Brothers collapse, it became increasingly difficult for non-US financial institutions to obtain USD funding. Due to unwinding of risky investments funded in USD, a dollar shortage emerged. This created a wedge between the funding costs of those financial institutions which had access to USD liquidity from the Fed and those who did not, i.e. a spread between on-shore and off-shore funding costs. The fact that the Fed has provided USD liquidity to foreign central banks through swap lines means that the dollar shortage has eased significantly in December (cf. figure 1), which could explain part of the move higher in EUR/USD (move lower in USD/DKK).

Turning to flow of funds data, we note that foreign demand for US long-term securities near collapsed in October. Although the net-flows into the US remain positive due to strong repatriation by US investors, there are now clear signs that foreign investors are also repatriating. Due to the lagging nature of the data one should not over interpret this, but it does point to a shift in the behaviour of foreign investors. Also, option market positioning currently indicates a slight bias for EUR (DKK) relative to USD.

Following Tuesday's decision by the Fed to lower its target rate to a range between 0 and 0.25%, the EUR-USD interest rate spread widened, adding further pressure on the USD. While the Fed is thus done cutting rates, we expect the ECB to lower rates by another 100bp during Q1 2009 to 1.5%. Also, we foresee a prolonged downturn in Euroland, whereas the US recession is likely to be deep yet short-lived. Hence, relatively speaking, we expect this to put pressure on the EUR throughout H1 2009.

During the autumn the Fed has been adding excess liquidity to the market, thereby keeping the effective Fed funds rate below the target. This has been partly financed by printing money, leading to a significant expansion of the Fed balance and monetary base (cf. figure 2). There has been a gradual move toward quantitative easing, with 25 November marking a key date as the Fed announced its intention to buy USD 600bn in Agency debt. This coincides with the move up in EUR/USD (moved down in USD/DKK).

Thus, a USD shortage, investor flows and quantitative easing have probably been the key drivers recently. Going forward, we expect economic conditions and relative interest rates to weigh on the EUR.

Fixed income: Fed's quantitative easing triggers a sharp fall in yields

The FOMC's decision on Tuesday to cut the fed funds rate to a historically low target range of 0-0.25% and switch to quantitative easing (see USA article) has resulted in a sharp drop in yields during the week on both sides of the Atlantic.

The slide in US yields began after the Fed announced direct purchases of USD 600bn in the MBS market (around 5% of outstanding housing debt) on 24 November to bring down mortgage rates. Then, in a speech on 1 December, Fed chairman Ben Bernanke opened up the possibility of the Fed purchasing long-term Treasuries. The combination of sharp falls in mortgage rates, the threat of the Fed buying up long-term Treasuries and the prospect of the Fed keeping its policy rate at zero for a lengthy period has sent long US Treasury yields down to historically low levels. How far long US yields are from hitting bottom is still uncertain, as this depends on whether the Fed acts on its threats to buy up Treasuries. That said, 10Y Treasury yields are now so low that further decreases can no longer be justified by fundamental factors.

The steep fall in long yields in the USA has fed through to the long end of the curve in Europe. Until Tuesday, this meant a flatter yield curve in Europe, as the ECB had for a while been indicating a degree of reticence in its monetary policy. However, the strong message from the Fed on Tuesday caused the market to reconsider the outlook for the ECB, resulting in a sharp drop in German 2Y yields and fresh steepening of the curve. The market is now in line with our forecast that the ECB will hit 1.50% during the spring.

In the light of recent weeks' events and market movements, we reckon that the risk over Christmas and New Year, especially in Europe, is towards further decreases in yields.

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