Weekly Focus

Fears of Financial Meltdown

Financial turmoil rocked the markets once again this week as a very negative cocktail of bad financial news and weak economic data put pressure on risky assets.

On the financial front several stories are weighing on sentiment. First, there is a lot of uncertainty over a large amount of funding that banks need to roll soon. Floating rate notes that were issued by banks in 2006 to borrow money will come due over the next year and a large chunk of that will expire over the next month when USD 95bn matures. Adding to uncertainties over funding in Europe was a tightening of collateral rules from the ECB aimed at stopping abuse of the collateral system by banks. Second, the problems facing the US mortgage giants Fannie Mae and Freddie Mac remain unresolved. The so-called GSEs (government-sponsored entities) need new capital due to losses on their portfolio of mortgages but private investors have been very reluctant to provide the necessary capital. The markets are now waiting for the US Treasury to intervene with a plan by which they will put government capital into the GSEs. The markets have waited for a while, though, and are losing patience. Over the week news that Chinese banks are selling Fannie and Freddie bonds have added to the pressure on the GSEs. A third factor pushing down risky assets is more stories of hedge funds in difficulty that need to liquidate assets. This was because stocks widely held by hedge funds have fallen more severely than the broader market over the past week.

On the macro front, weak data on US retail sales and unemployment added to a picture of an economy that is facing strong headwinds in the second half. Second quarter growth recovered but mainly due to strong exports and the boost to consumption from the tax cut. With global growth weakening and the tax boost reversing the talk of US recession is resurfacing.

Euroland: ECB happy with its key rate

It has been an eventful week, with the rate-setting meeting at the ECB its natural climax. As expected, the ECB left its key rates alone, and the tone of the press conference was relatively neutral, with Jean-Claude Trichet saying that the bank has no bias. In other words, the ECB is quite happy with interest rates the way they are.

The week also brought news of a further deterioration in German industrial production, which fell by more than 1.8% m/m in July, continuing its underlying downward trajectory after a slight rally in June. Industrial production is now below last year's levels. German manufacturing companies also saw a decrease in new orders, with both the domestic and export markets slackening.

The coming week will tell us how industrial production fared in Euroland as a whole in July. There is much to suggest a decrease, and we predict a drop of 0.2% m/m. The week also brings final inflation figures for Germany, Italy and Spain, which we expect to be in line with the provisional flash estimates.

Jean-Claude Trichet will be speaking on Wednesday and Thursday, and the ECB monthly bulletin is due out on Thursday.

Key events of the week ahead

• Industrial production data for France, Italy and Euroland.
• Final HICP inflation figures for Germany, Italy and Spain. We expect no change from the flash estimates of 3.3%, 4.2% and 4.9% y/y respectively.
• German foreign trade figures will come under the spotlight on Tuesday.

Switzerland: Financial sector continues to pull down growth

The past week saw the publication of national accounts data for Q2, which confirmed our expectation of a continued slowdown. The figures did surprise slightly on the upside, with real GDP accelerating from 0.3% q/q in Q1 to 0.4% q/q in Q2, but year-on-year growth is still falling, down from 3.0% in Q1 to just 2.3% in Q2. Private consumption made the biggest contribution to growth in H1, but there was also a positive contribution from net exports. Looking ahead, we do not expect private consumption to continue to make a major positive contribution, as consumer prices have climbed and consumer confidence has been fading.

Looking at the individual sectors, the financial sector once again made a negative contribution to growth (-0.35% q/q), as was the case in Q1. This shows how much pressure the financial sector is under at the moment due to the global credit and liquidity crisis. The financial sector is now sucking more than half of the growth out of the economy, after having itself contributed to half of Swiss economic growth for several years. However, the negative growth in the financial sector is being more than offset by strong manufacturing and export sectors, which were the most important growth sectors in H1. That said, the contribution from the export sector did fall back slightly in Q2, leaving it to the manufacturing sector to prop up growth.

The past week also brought the publication of consumer prices for August. These fell 0.3% m/m, which was further than anticipated, taking year-on-year inflation down from 3.1% in July to 2.9% in August. Once again it was falling oil prices that pulled down prices, but energy prices are still higher than a year ago, keeping year-on-year inflation up at a high level. Finally, Thomas Jordan from the Swiss National Bank gave a speech on Tuesday at a Swiss Venture Club event. In general he signalled a neutral monetary policy stance and reiterated that the SNB expects inflation to fall back below the 2% target in 2009. We interpret this speech as confirmation that the bank is on hold, and expects the 3-month Libor target to be left unchanged on 18 September.

The past days have also seen a decent strengthening of the Swiss franc and EUR/CHF is now trading below 1.60 for the first time in more than a month, as global equity performance has been weak and volatility has edged higher. We feel comfortable with this move below 1.60, which has taken the cross back at levels more in line with our short-term financial models. There is relatively little on the agenda in Switzerland in the coming week, the only significant figures being for August unemployment, due 07.45 CET on Monday

Key events of the week ahead

• Monday brings unemployment figures for August. The consensus expectation is for an unchanged seasonally adjusted unemployment at 2.5%.
• Wednesday: SNB's Hildebrand speaks in Geneva at 12.15 CET and SNB's Jordan in Zürich at 15.00 CET.

USA: Tax package won't last forever

Domestic demand stateside will remain weak in the coming quarters. Private consumption has been propped up by the government's tax rebates, but as these payments are a one-off, their positive effect will not last forever. Although consumers have held back and not blown the whole cheque in one go, the outcome will still be a net negative contribution to private consumption growth from late Q3 this year. The coming week brings retail sales figures for August. We were a little surprised to see auto sales increase quite significantly in August, but we expect the underlying trend in retail sales to be weak.

The past week has brought an update from the Federal Reserve's regional offices in the form of the Beige Book. The overall conclusion of the report, which is based on data collected up to 25 August, is that the growth outlook remains weak. The Fed districts generally reported a weaker labour market and further deterioration in the housing market. Industrial production was found to be slackening, and it is interesting to note that several districts reported falling growth in export orders. To some extent this contradicts the message from the ISM report on the manufacturing sector, which showed an increase in the index for export orders to 57, where a level above 50 indicates positive growth. Generally speaking, the ISM index has not been able to predict the slide we have seen in actual industrial production in recent months. The reason for this is probably that the percentage of export companies in the ISM survey is higher than the actual percentage in the overall industrial sector. We do not anticipate a collapse in the manufacturing sector, but a stronger USD and a weaker global growth outlook will put a damper on export growth going forward and so pull down the ISM index.

There will be some focus on Dallas Fed governor Richard Fisher's speech in the coming week, as he is currently the last FOMC member scheduled to speak before the next rate-setting meeting on 16 September. Fisher is a voting member and a renowned hawk, so it will be interesting to see if he softens his tone a little in the light of lower commodity prices and a weaker global growth outlook. The University of Michigan consumer sentiment index for September will also be released during the week. We expect a small increase, driven by the drop in gasoline prices. The coming week also brings producer prices for August, which will be dragged down by the fall in oil prices.

Key events of the week ahead

• Monday: Fed's Fisher speaks in Austin.
• Friday: We forecast a decrease of 0.6% m/m in producer prices.
• Friday: Strong auto sales should ensure decent growth in overall retail sales in August, but the underlying trend in retail sales will be weak.
• Friday: Michigan consumer sentiment will probably edge up to 64.5 due to the drop in gasoline prices..

Asia: Japanese Prime Minister Throws in the Towel

Japanese premier Yasuo Fukuda announced his resignation during the week after less than a year in office (see Flash Comment -Japan: PM resigns -increases likelihood of fiscal easing), but this did not really come as any great surprise: he was unpopular, and elections to the lower house have to be held by September next year, so there has always been an expectation that he would hand over the reins well before the elections. Former foreign minister Taro Aso is a clear favourite to take over as prime minister. Within the ruling LDP party, he has been an advocate of easing income taxes and pushing back the 2011/12 target for balancing the primary budget. Fiscal policy easing would therefore be more likely if he were to take over as chairman of the LDP and prime minister. The Bank of Japan therefore now has another argument in favour of leaving its key rates unchanged despite the feeble state of the economy. In the coming week, the already very weak Q2 GDP growth of -0.6% q/q is set to be revised down further to -0.8% q/q, as fresh information suggests that business investment was worse than expected.

In China, the picture is currently one of slowing export growth on the one hand and improving private consumption on the other. This will probably be confirmed by the publication of foreign trade and retail sales figures for August during the week. Private consumption is currently being boosted by the downturn in inflation in China, due mainly to falling food prices. Inflation figures for August will also be released during the week, and these will probably show that inflation has moved below 6% y/y, which makes it increasingly likely that inflation will drop below 5% before the year is out. On the plus side, this means that the Chinese administration now has greater scope to stimulate economic growth if the economy were to slow too sharply.

Key events of the week ahead

• In China, consumer prices are due on Thursday, retail sales on Friday, and foreign trade figures during the course of the week. All are figures for August and may therefore be affected by the hosting of the Olympics in Beijing.
• In Japan, the main focus will be on the political situation, where we should find out whether Taro Aso will have any challengers for the post of PM. Revised GDP figures are due out on Friday and will probably show a downward revision of already very weak growth.

Foreign exchange: Australia cuts, Sweden hikes, the world keeps on turning

The Riksbank in Sweden raised its key rate by 25bp to 4.75% during the week. This in itself was no surprise, and the most interesting thing in the ensuing press release was the revision of the interest rate path for 2009 to include an expected 25bp rate cut. Given the sharp slowdown in the Swedish economy and a steep drop in inflation, however, we expect the key rate to be lowered by around 1pp in 2009, starting in Q1. The prospect of a narrowing of the interest rate spread to Euroland, continued strong pressure on the financial sector and deterioration in the global economy suggests that the SEK could remain relatively weak. While the EUR/SEK has been trading in the 9.25-9.45 band (DKK/SEK 0.79-0.81) for most of this year, we expect this band to tick up to maybe 9.35-9.55 (0.78-0.80), and the top of the band could well be tested. For further information, see our Riksbank comment.

On the other side of the world, the Reserve Bank of Australia cut its key rate by 25bp to 7.0%, its first cut since 2001. This was one reason for the recent sharp deterioration in the AUD, the AUD/USD now having lost more than 15% since mid-July. As with the NZD earlier this year and the GBP at the end of 2007, this goes to show that an overvalued currency coupled with a substantial current account deficit is particularly vulnerable to a shift in the monetary policy cycle. We expect the RBA to cut its rates further in the coming year. As we also expect our two central themes of financial crisis and global economic slowdown to put a damper on the FX market's appetite for interest-rate arbitrage, we anticipate further AUD depreciation. Our latest 12-month forecast for the AUD/USD of 0.80 will soon be overtaken by reality, and although we see the risk of a short-term correction, the conclusion is that we will need to revise our forecast down in our next forecast update on 15 September.

The Bank of England left its rate unchanged, but the Chancellor saw fit to announce that the UK is facing its most serious economic downturn for 60 years, which was something of a poke in the eye for the GBP during the week, lifting the EUR/GBP to a new high of 0.8175 and pushing the GBP/DKK down to 9.10, its lowest since 1996. Although a lot of bad news is already priced into the GBP, the next couple of months will probably bring further depreciation. We have therefore raised our three-month forecast for the EUR/GBP from 0.81 to 0.82 and see the risk as primarily on the side of a weaker GBP.

In Euroland, the ECB also left its rates unchanged and gave no real indications of imminent changes. However, it did toughen its rules on the securities that banks can put up as collateral for loans from the ECB. This effectively means a tightening of the liquidity cycle in Europe at a time when the economy is slowing rapidly. This is not good news for the EUR, which fell to its lowest level against the USD since the start of 2007. Our 12-month EUR/USD target of 1.40 will soon be within reach, and although a technical correction may seem inevitable, we still think that the primary trend is towards a weaker EUR.

For a discussion of the outlook for both Japanese policy in the wake of prime minister Yasuo Fukuda's departure and the JPY, see FX Crossroads: Positive on JPY, negative on AUD and GBP.

Fixed Income: Downward pressure on bond yields continue

After trading sideways for some time, the declining trend in bond yields resumed late in the week. The policy meeting at the ECB didn't move short rates much, although they eased slightly because of the marginal softening of the central bank's tone. However, the ECB still finds the current policy rate appropriate and hence is not signalling rate cuts in the near future (see Flash Comment -ECB: A fairly neutral statement). However, after the ECB meeting on Thursday, bond yields moved sharply lower on the back of renewed financial turmoil and bad US job numbers. We believe the declining trend in bond yields will continue in the coming months as growth weakens further and lower oil prices reduce inflation concerns.

On the other side of the Atlantic, US yields have continued to edge down as they have done since mid-June, both at the long and the short ends. The fall in yields is driven by a combination of renewed concern about the financial system, plummeting oil prices and the outlook for a sharp downturn in GDP growth in H2. The market has now postponed the expected Fed rate cuts until next summer. The coming week's key event will be the release of US producer prices and retail sales for August. The ongoing fall in oil prices should now begin to show up in inflation data. Moreover, retail sales data indicate that the effects of the tax rebates are wearing off. If indicators in the coming week confirm the picture of sliding growth and inflation, we believe yields could continue to move downwards.

However, the joker in the pack in the coming week will again be the financial crisis. If a solution is found to the problems at Freddie Mac and Fannie Mae, this could lift Treasury yields while pushing down swap rates. On the other hand, a worsening of the situation at the banks that will need to roll a large chunk of funding in months ahead could send yields further down. All things considered, we consider it most likely that yields will continue to edge down in the coming week, although uncertainty is looming large at the moment.

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