Weekly Focus

Euroland: ECB in Coordinated Rate Cut

Another eventful week for the Euroland economy. While there was not much news on the economic data front, the financial markets and the coordinated rate cut by a string of major central banks hit the world's headlines. The ECB was one of the banks to cut by 50bp, and in our view the ECB will deliver further cuts in the coming months. We still forecast the ECB to cut by 25bp in December 2008 and by the same amount in February and April 2009, bringing the key rate down to 3.0% by summer 2009.

The coming week looks relatively quiet as regards data. Among the most important will be the German ZEW indicator. Given the severe financial turmoil of recent weeks, we are looking for a hefty fall that will more than wipe out the gains of the past two months. More specifically we expect that the expectations index will come in at -65, a new record low.

Key events of the week ahead

• Tuesday: German ZEW. We foresee the expectations indicator falling to -65, which would be a new record low. September inflation numbers for France and Italy and industrial production in Euroland also due.
• Wednesday: Inflation in Germany in September.

Switzerland: Were rates cut by 25bp or 50bp?

On Wednesday the Swiss National Bank decided to cut interest rates as part of a coordinated move with other large central banks to reduce monetary policy rates by 50bp. Or did it? Although the SNB said in its press release that it was easing conditions in the money market by 50bp, it actually lowered its target for the three-month LIBOR by just 25bp to 2.5%. So how should we interpret this?

Monetary policy in Switzerland is very different to that at most other central banks. Whereas other central banks mainly target a short-term money market rate, the SNB implements its monetary policy through a three-month rate - and one that is not even set in Switzerland, but in London, namely the three-month LIBOR. Given that the SNB cannot dictate an interest rate that is set in London, it instead sets a target range within which it wants the three-month LIBOR to trade. To achieve this, the SNB uses a number of short-term money market instruments, where the most important is the one-week repo rate. In the weeks leading up to the coordinated rate cut, the three-month LIBOR had climbed to more than 3% and was therefore well above the target of 2.75%. On Wednesday the SNB announced that it would try to lower the three-month LIBOR by 50bp to a new monetary policy target of 2.5%. Thus the bank has really only reduced its policy rate by 25bp, and the three-month LIBOR is actually still fixed above 3%.

However we interpret the SNB's rate cut marks a turning point in the Swiss monetary policy cycle. This is an important signal from the bank, not least because the cut was made outside its scheduled quarterly meetings and came less than a month after its last such meeting. Despite deterioration in the growth outlook since that meeting, we interpret the week's rate cut primarily as a shift towards a sharper focus on the problems in financial markets. The market reaction has been limited, though, as the market was already discounting a certain chance of a rate cut. However, the Swiss yield curve has steepened significantly since the September SNB meeting, with the two-year government yield falling almost 60bp to 1.10% and the ten-year government yield falling by 5bp to 2.65%. CHF has generally been on the up recently, with the result that the CHF/DKK cross is trading around 4.90 and thus above its peak in mid-March. As long as the problems on the money markets remain unresolved, we see no reason why CHF/DKK should not rise further (see Foreign Exchange section).

So what should we make of Wednesday's intervention? We consider the rate cut to mark an important shift of focus and expect the SNB to ease monetary policy further, albeit by less than the ECB. In the first instance, though, the SNB needs to concentrate on getting the three-month LIBOR back on target. Only then can we expect further rate cuts. If the SNB manages to keep the three-month LIBOR around its target, we reckon it likely that it will cut again, possibly as early as its December meeting.

Key events of the week ahead

• Monday 09.15 CET: Producer and import prices for September.
• Wednesday: Weekly government meeting in Berne.
• Thursday 09.15 CET: Real retail sales for August (nb. tends to fluctuate widely).
• Thursday

USA: Financial crisis will tip US into recession

The US has been hit by two serious shocks in recent quarters: soaring oil prices and the crisis in the financial markets. While the former has eased considerably since July, when oil prices peaked, the financial crisis has greatly intensified. Despite the very considerable efforts of the Federal Reserve and the US authorities to re-establish stability in the financial system, the situation in the money and credit markets has seriously deteriorated in recent weeks. Our risk scenario for the US economy therefore looks like becoming a reality, and so we have revised down our forecasts for growth and monetary policy rates.

We now expect the US to slide into recession on the back of the deep slowdown in both consumption and investments. Further credit tightening, market rates that are far above monetary policy rates and negative wealth effects due to plunging share prices are dragging private consumption down. Meanwhile, a marked slowdown in demand and rising financing costs will cause a sharp fall in business investments. Further, weaker global growth will mean weaker export growth in the coming quarters. Given the downward adjustment to our growth scenario, we now expect that the Fed will cut interest rates by a further 25bp at its policy meeting in October and again by 25bp at the meeting in December.

The US authorities have already taken quite drastic steps to ensure stability in the financial system, and the Fed showed by its coordinated rate cut on Wednesday that it is ready to use all means at its disposal. We expect to see further actions by the authorities in the coming days and weeks until the financial system shows some sign of improvement. The financial crisis will dominate the G7 meeting this weekend, which could provide an opportunity for politicians and central bankers to coordinate a global political initiative that would send a clear signal to the markets that the financial crisis is being taken seriously. Focus in the coming week will be on Bernanke's speech and the Fed's Beige book (both Wednesday). There is also a string of economic data due for release, the most important being retail sales (also Wednesday), where we expect to see further weakness, consumer confidence for October (Friday), and a number of housing market-related figures that will provide some measure of the health of that part of the economy.

Key events of the week ahead

• Wednesday: Bernanke speech
• Wednesday: Fed's Beige Book released
• Thursday: We expect unchanged consumer prices in September and core inflation to rise 0.2%
• Thursday: We expect an unchanged NAHB housing index at 18 in October
• Friday: We expect a fall to 68 in the University of Michigan's consumer confidence index for October

Asia: Asia follows American and European lead and lowers rates

China, South Korea, Taiwan and Hong Kong cut interest rates during the week, and India and Singapore indicated that they too will now be easing monetary policy, albeit without an actual rate cut. It therefore seems that Asia will be easing monetary policy rather earlier than we anticipated. We had expected the Asian central banks to hold fire until the end of the year due to persistently high inflation, but the turmoil in financial markets and the latest tumble in oil and commodity prices have convinced them that inflation will probably not be the big problem next year.

The Bank of Japan opted to leave its key rate unchanged at 0.5%, arguing that Japanese monetary policy is already very easy. The BoJ probably felt that the situation in Japan is not yet sufficiently desperate for it to fire its final round. The bank also pointed out that the Japanese money market has been functioning better than those in the USA and Europe. This is further evidence that it will probably take more for the BoJ to cut its key rate - either growth will need to be extraordinarily weak, or the global financial crisis will have to call into question the financial stability of Japan. Neither of these two possibilities can be ruled out, so there is currently some downside risk to our forecast that the BoJ will be on hold for the next year.

Deputy finance ministers from China, Japan and South Korea are due to meet in connection with the coming week's IMF and World Bank meeting. The creation of an Asian monetary fund has again moved up the agenda. The idea behind the fund is to help stabilise Asia's currencies. Originally the idea was to take a final decision in May 2009, but it seems that these plans may be brought forward, due in part to the recent slide in the KRW, which has been seen as a problem in both South Korea and Japan (see Research - Korea: Vulnerable but not a repeat of ‘97). The current plan is for the fund to have capital of USD 80bn.

Key events of the week ahead

• No big news is expected in Japan during the week. Tuesday brings current account data for August.
• Trade balance and currency reserves figures for September are due out in China during the week. There will be a particular focus on how exports are faring.

Foreign Exchange: Defensive Currencies are Your Best Friend

The news flow in the past week has been so intense that it can be hard to keep up with all the drastic actions prompted by the escalation of the financial crisis. To our mind, it is worth highlighting the following four developments: 1) Late on Friday the US House of Representatives approved a revised version of the USD 700bn rescue package to restore confidence in the financial sector and limit the damaging effects of the financial crisis on the real economy. 2) On Wednesday the big Western central banks and the People's Bank of China tried to present a united front by cutting their monetary policy rates simultaneously. Other Asian central banks have subsequently followed this up with a similar action. 3) On Tuesday the UK government and the Bank of England launched a recapitalisation and liquidity package as "a necessary condition for regenerating confidence in the financial system". 4) On Monday an almost unanimous Danish Parliament presented, together with the Danish banks, a rescue package for the Danish financial sector.

For some time now, one key element in our FX analyses has been that the global economy is moving towards recession. Since the USA has been willing to use virtually all possible means to avert economic disaster, while until now Euroland has largely just been hoping for the best, we have been comfortable with a lower EUR/USD forecast. And we still are. We have also been positive about the JPY and the CHF, which were also the best-performing currencies overall in the last three global recessions (1990-1993, 1998 and 2001-02). These two currencies are no longer seriously undervalued against our benchmarks - the USD and EUR respectively - but may nevertheless continue to strengthen if risk aversion remains high. The SEK and NOK have weakened to levels against the EUR that mean that they are gradually coming to represent quite good value, while the GBP is still in the danger zone due to the bleak domestic outlook.

The currency movements we have seen in recent months may continue if the risk of global recession is replaced with fears of a global depression. However, there are a number of ways of avoiding this. First, there is a need for major injections of liquidity. Second, there is a need for further rate cuts. Both of these are already anticipated in the market. Third, public sector demand can be boosted through expansionary fiscal policy, which does take time but is also one of the most effective instruments. Finally, the international community can make sure that no protectionist beggar-thy-neighbour policies are introduced, as a down-turn in global trade would have harmful long-term effects.

We have no plans to try to predict when the market will bottom out. So for the time being our expectation is for more of the same. That said, the downturn in high-yielding currencies against low-yielders has been extreme, so it might pay to be aware of the opportunities here. We think it is still too early to reopen carry trades, as the downside risk is still considerable, but investors willing to take a punt might begin to consider such strategies.

Fixed Income: Massive intervention fails to ease uncertainty

The global financial crisis reached new heights in the past week, with credit and money markets facing apparently overwhelming problems and equity markets dropping like a stone. The rapid acceleration of the crisis prompted drastic intervention by authorities around the world: central banks have significantly expended their liquidity programmes; the US Fed now allows companies and banks to borrow directly from the central bank without providing collateral; in Europe, the ECB has removed the ceiling on how much money can be borrowed at its weekly auctions; the British government has announced a huge capital injection for the bank sector; and finally, a coordinated action by the US Federal Reserve, the ECB, and the central banks of Britain, Canada, Switzerland and Sweden saw interest rates cut by 50bp on Wednesday. Moreover, we expect to see further rate cuts from all of these central banks (see Flash Comment - Global: Coordinated central bank action).

Whether these measures will be sufficient to stabilise the financial markets is as yet unknown. Such drastic steps do, however, highlight that the seriousness of the situation is now glaringly clear to the authorities. Hence, one can expect that new initiatives will continue to be launched until the markets show some sign of improvement. This means that uncertainty in the fixed income markets will continue to be high. Direction will, as in the past couple of weeks, be largely determined by the course of the crisis and the authorities' reactions, rather than the macroeconomic data. This weekend's G7 meeting could therefore be interesting with respect to whether agreement can be reached on a coordinated global response.

That said, there are still some interesting numbers due in the coming week. As the world's central banks have now dismissed inflation fears and shifted their focus to growth, it will be growth data that will grab attention. Retail sales and construction data for September are due in the US, while Euroland has the ZEW indicator for October. In general we expect these numbers will confirm that the slowdown is continuing. Apart from the data, focus will be on speeches by Trichet (Tuesday) and Bernanke (Wednesday).

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