Weekly Focus

Money, Money, Money

A key issue in the financial crisis at the moment is the tensions in the money markets. This is evident in the sharp rise in money market rates seen in recent weeks around the world - not least in the US.

The trigger for the renewed tensions was the bank-ruptcy of Lehman Brothers on 14 September. This had several implications. First, perceived counterparty risk went up as fears of other bankruptcies swept through the system. Banks therefore became even more reluc-tant to lend money to other banks. Second, the collapse of Lehman Brothers led to big losses for the oldest US money market fund, Reserve Primary MMF, which "broke the buck". This means that investors experi-enced real losses on funds invested in the Reserve Primary MMF, as net asset value went below USD1. This was the first time since 1994 that a money mar-ket fund had broken the buck. The incident led to a flight of money out of money market funds in the US.

Money market funds are a crucial provider of liquidity to financial institutions through their purchase of Commercial Paper (CP) from financial institutions. CPs are obligations of short maturity used to raise liquidity by companies. However, the flight from money market funds reduced the capital in these for purchasing CPs, and at the same time it made the funds much more conservative, shifting their demand for assets from CPs to safe US T-bills. The shift is apparent in the out-standing volume of US CPs to financials, which has come down rapidly in recent weeks (see middle chart). Financial institutions are therefore finding it much harder to raise liquidity in the CP market. These ten-sions could lead to a negative spiral, as counterparty risk goes up even further when liquidity scarcer.

Euroland: ECB paves way for rate cut

It has been an eventful week, with the rate-setting meeting at the ECB the clear highpoint. As expected, the ECB was not yet ready to lower its rates at the meeting on Thursday. The tone at the press conference was noticeably softer than at the previous meeting, though, signalling that the ECB is en route for a rate cut. The softening extended both to the growth outlook, where there was particular emphasis on the downside risks from the financial crisis, and to the assessment of the upside risks to inflation, which the ECB believes have receded but not disappeared. In light of Thursday's meeting, we still expect the ECB to cut its key rates by 25bp in December and then again in February and April next year. In our view, though, the ECB's softening does mean that the chances of an earlier rate cut are greater than before the meeting. Finally, the compos-ite PMI for September came out at 46.9, which suggests that Euroland saw a slight decrease in output in Q3 and has therefore been in a mild recession for the last two quarters.

The coming week is relatively quiet, with few important figures for the Euroland economy due. Tuesday brings statistics for German manufacturing orders, while Wednesday sees the final national accounts for Euroland in Q2. We expect these to show negative GDP growth of 0.2% q/q, confirming the flash estimate. Wednesday also offers industrial production data for Germany in August. The weak new orders of recent months mean that, like consensus, we expect production to fall a further 0.5% m/m, corresponding to a drop of 2.7% y/y.

Key events of the week ahead

• Tuesday: German manufacturing orders.
• Wednesday: Final national accounts data for Euro-land in Q2. We expect the flash estimate to be con-firmed, which means a decrease in GDP of 0.2% q/q. German industrial production is expected to fall by 0.5% m/m.
• Thursday: German foreign trade figures.
• Friday: Industrial production data for France and Italy.

Switzerland: Is a small decline in GDP really that much worse than a small increase?

As the focus of the markets in the past week has remained on the financial crisis and the "deal or no deal" being played out in the US House of Representatives, the macroeconomic data have taken something of a backseat. However, the past week saw a string of important numbers for Switzerland. The manufacturing sector reported slowing production for the first time since 2005, as the PMI index for September fell to 47.8 and hence into slowdown territory below 50. However, employment intentions remained decent, wit-ness to a Swiss labour market that, despite slowing economic activity, remains tight. Meanwhile, Tuesday's consumption indicator for August showed that consumption still looks healthy, though the outlook has dete-riorated significantly for households. And while we still expect inflation to fall below the SNB target during 2009, the September number rose unexpectedly by 0.1% m/m compared to -0.3% m/m in August.

Economic data have generally been weak of late, not least due to the faster than expected slowdown in the euro zone, which the Swiss economic research units have reacted to. Hence, the past week saw new fore-casts from three of the most important institutions, SECO, KOF and the Swiss National Bank (SNB), who all published weak growth expectations.

The KOF (Konjunkturforschungsstelle) economic research unit became the first to use the "R" word, as its latest forecast foresaw negative growth in both Q4 this year and Q1 next year, which adds up to a technical recession. "But is a small decline in GDP really that much worse than a small increase?" asked the acting OECD chief economist, Jørgen Elmeskov, recently in a discussion of the UK's economy. He answered his own question by saying "I think not." Recession or not, economic activity is clearly slowing in Switzerland, and this is also the expectation of SECO (State Secretariat for Economic Affairs), which on Thursday pre-sented its new forecast. SECO maintained its projection of real GDP growth at 1.9% y/y in 2008 and 1.3% y/y in 2009, but added that it now sees a considerably higher risk to growth next year.

Overall one could conclude that: economic growth is heading below potential; there is a risk of negative growth over New Year; major export markets look in even worse shape; Switzerland will probably soon ex-perience a turnaround on the labour market, with higher unemployment as a result. That said, the slowdown in Switzerland, seen from a macroeconomic perspective, has so far been a ride on first class (or perhaps business class) compared to the major Western economies.

Key events of the week ahead

• Friday at 07:45: Unemployment rate for September. Consensus expectation is for an unchanged 2.5% (seasonally adjusted).

UK: Rate cuts needed - the sooner the better

The UK economy continues to deteriorate, as was evidenced in the past week when PMI data for both manufacturing and services showed further declines. PMI levels now very clearly point to a UK economy go-ing into recession. House price data over the past week also showed further falls. The Nationwide survey showed a further decline of 1.7% m/m in September, taking the overall decline from the peak last October to 13% - prices are now back at levels seen in early 2006. Overall, we see scope for a further decline of around 10% in UK house prices over the coming year, which will put affordability back at long-term levels. The risk is, though, that we will see an overshoot due to the financial crisis.

The door is opening fast for an easing of UK monetary policy on the back of the financial crisis escalating and worse than expected economic data. Inflation pressures, meanwhile, have eased a bit, as commodity prices have seen heavy falls. A weaker economy will also reduce inflation pressures in the medium term. This week we changed our forecast for the Bank of England, now expecting it to start cutting in November and to follow up with cuts in each of the five following months (see Flash Comment UK - Revised BoE rate forecasts). This would take the bank rate down from 5% to 3.5% by April next year. There is even a decent chance that the Bank of England could cut as early as its meeting next week - especially given the weak PMI data, which sealed the UK's fate in terms of a possible recession.

Key events of the week ahead

• Monday: Industrial production likely to have declined again in August
• Thursday: Bank of England to meet. Clear chance of rate cut, although our main scenario is that it waits until November.

USA: Huge decline in industrial activity

All eyes were again on the financial crisis this past week, when a no in the House of Representatives on Monday to a rescue plan hammered out by high ranking Republicans and Democrats over the weekend caused renewed turmoil in the markets. On Thursday the Senate presented a revised plan with a string of tax sweeteners tacked on in an attempt to woo wayward Republican votes (see Flash Comment - USA: Sen-ate votes yes to revised plan, House to vote again on Friday ). The House will likely to vote on the new plan on Friday evening.

If the revised rescue plan is passed it will mark a very important step towards stabilising the financial sys-tem. However, the question still remains of how great the fallout will be on the real economy of the recent stress experienced by the financial markets. Some indication of this was provided by Wednesday's ISM manufacturing number, which fell sharply to a recession-like level (see Flash Comment - USA: ISM data at re-cessionary levels). The ISM had hovered considerably higher than actual growth in industrial production for some time, and we had been expecting a fall for several months. Nevertheless, the collapse seen on Wednesday was greater than our model had suggested. The weak ISM probably reflects a reluctance by the industrial sector to place new orders in September, when uncertainty was high and companies found it in-creasingly difficult to obtain financing.

The escalation in the financial crisis and gloomier prospects for growth have prompted the market to price in a 50bp rate cut at the Fed's next meeting on 29 October - and indeed otherwise hawkish FOMC member Posser softened his rhetoric somewhat in the past week. The week ahead will see a number of FOMC mem-bers speak, the most important being Ben Bernanke's speech in Washington on Tuesday evening. The min-utes from the latest FOMC meeting, held on 16 September, will be released on the same day. It will be inter-esting to see the committee's deliberations on the consequences of the financial crisis and to what extent the members were informed of the Treasury Secretary's rescue plan when they met.

Key events of the week ahead

• Monday: Fed's Fisher to speak on the economy and monetary policy
• Tuesday: Minutes of FOMC meeting 16 September released
• Tuesday: Bernanke to speak on the economy and the markets in Washington
• Friday: Trade deficit figures for August, consensus expects a fall

Asia: Japan in recession, but still hope that it will be mild

The important Tankan business confidence survey was published during the week. On the surface, it paints a bleak picture of the Japanese economy (see Flash Comment - Japan: Tankan indicates Japan is in reces-sion). As can be seen from the chart, movements in the Tankan index suggest that Japan is now in reces-sion, and the main risk to our current forecast for Japan is that growth will turn out weaker than expected. Our current forecast assumes that Japan is indeed thrown into recession, but that the recession proves milder than those of 1997/98 and 2001/02. Our view that the recession will be relatively mild is based on an expectation that both exports and business investment will fare better than in the last two recessions.

There is also some support for this view in the Tankan survey. While exports have deteriorated, they are still markedly better than in the last two recessions. For one thing, Japanese exports are heavily dependent on growth in the rest of Asia, which plummeted in 1997/98, and on business investment, which fell sharply during the global downturn of 2001/02, a downturn driven especially by excess capacity and falling busi-ness investment globally. Although Asia is now shifting down a gear, we still reckon that Asia will deal rela-tively well with the present global downturn - and this should be a big plus for both exports and business in-vestment in Japan. Furthermore, the financial sector and the housing market in Japan were still very fragile during the recessions of 1997/98 and 2001/02. This time, however, the financial sector and the housing market are far better equipped for the global credit crisis than those in Europe and the USA. Japan has al-ready been through the hangover that follows the collapse of a financial bubble, and therefore has a better chance of escaping relatively quickly from the present downturn.

Centre of attention in Japan in the coming week is the monetary policy meeting at the Bank of Japan (BoJ). Like consensus, we expect the BoJ to leave its policy rate unchanged at 0.5%, and we do not expect any ma-jor changes in tone from the previous meeting. The main message will still be that the current highly expan-sionary monetary policy is appropriate given the major downside risks to the economy, and so the BoJ will be on hold for the foreseeable future. We forecast that the policy rate will be unchanged at 0.5% for the next 12 months, and that a rate cut could only come as part of a co-ordinated international effort to stabi-lise global financial markets. The 12m overnight forward rate is currently 0.46%, which is still very close to our expectations.

Key events of the week ahead

• In Japan, the BoJ will announce the outcome of its monetary policy meeting. We expect an unchanged policy rate of 0.5%.
• In China, the Central Committee is holding a summit on Thursday and Friday. This will undoubtedly in-clude discussion of fiscal policy easing.
• There are monetary policy meetings in the Philip-pines on Monday, Indonesia on Tuesday, Thailand on Wednesday and South Korea on Friday. In all four cases we expect unchanged rates.

Fixed Income: Rate cuts move close as crisis deepens

The revamped USD 700bn rescue package returns to the US House of Representatives today, with a vote likely later in the day. We expect the package will be passed, as the consequences of a second rejection are almost too enormous to contemplate. The fate of the bailout plan will completely dominate the agenda today, and will shape market sentiment for the coming week.

Even if the package is passed, however, it is far from certain that it will herald the end of the financial crisis. Its impact will be slow in coming, and there are still a string of problems, not least in the money markets, which are completely frozen. The initial boost to sentiment when the package was first mooted has comp-letely evaporated, and general risk appetite will probably again guide the markets and thus yield movements in the week ahead.

Perhaps the most eagerly awaited event next week is the minutes of the 16 September US Fed meeting. There was considerable speculation ahead of the meeting that the Fed would cut interest rates as the finan-cial crisis reached new heights. However, in our view, the Fed will wait to see if the crisis has a clearer im-pact on the real economy before it cuts. That said, more or less all recent US economic numbers have di-sappointed and the chances of a further rate cut have increased.

In Euroland the prospects of rate cuts moved closer on Thursday, when the ECB toned down its concerns on inflation at the same time as sounding considerably more pessimistic on growth and stressing the risks stemming from the financial crisis. A softer ECB combined with a still raging financial crisis added up to a sharp fall in yields. Swap spreads (difference between government yields and swap rates of the same matu-rity) remain high due to spill-over effects from the high fixings on the money market.

The market is now pricing in 120bp of rate cuts from the ECB in the coming year. This is a rather aggressive course for the ECB and should form a bottom for how much further short government yields can fall. Short swap rates will be at least equally dependent on how the financial crisis develops.

Foreign exchange: How fat is the tail?

Economic numbers in the past week have been alarmingly weak. Manufacturing PMI activity indices are col-lapsing the world over: in the UK it fell to 41, in Sweden to 42.3, in France to 43, in the USA to 43.5 and in Ireland to 43.7. Remember that anything below 50 indicates a slowdown and levels below 45 are usually only seen in conjunction with a recession. In Japan, industrial production fell 6.9% y/y. However, it is not just industry that is exhibiting weakness. Euroland unemployment rose for the third straight month and has now risen in four out of the past five months. House prices in the UK and the US fell record-fast (down 12.4% and 16.3% y/y, respectively). Only China managed a positive surprise, as its PMI rose to 51.2. The conclusion is relatively simple: the US would have to be lucky to avoid a recession, Japan is on the brink of one, and a recession in Euroland now looks inevitable. Hence, the outlook for a large chunk of the global economy remains rather negative.

As regards the financial crisis - our other major theme of the past year - the past week has been something of a rollercoaster ride. While the movements have been exceptional, and while the financial sector has had so much cash and guarantees showered upon it that a relief rally could be on the cards before the end of the year, we would also like to emphasise that the root cause of the crisis is not that easy to resolve. An ex-ceptionally positive liquidity cycle between 2002 and 2007 resulted in enormous financial gearing and sharply falling risk premiums and volatility. According to the IMF, we are still not even halfway to writing off the losses in the financial sector. While it is far from certain that the second half will be as brutal as the first, no-one knows for sure. In a normal (Gaussian) distribution the probability of an extreme outcome is assumed to be symmetrical and also to converge towards zero. In the real world, the tail of the distribution is "fat", with a positive probability for the extreme outcome - and at this moment, the money markets in par-ticular are suffering from a lack of understanding of the fatness of the tail. For a look at the prospects for FX markets in three different scenarios for the financial markets, please refer to the latest FX Crossroads.

The past week's movements on FX markets have been relatively predictable: Among the top performers were JPY, USD and CNY, among the worst were ISK, HUF and AUD. The tumble in the ISK was alarming: al-most 15% just in the past week and 70% in 2008 so far. EUR/USD has fallen to a new low-point for the year at 1.3748. Although we would emphasise that fluctuations could be rather unruly, we still believe that EUR/USD could fall further. Not surprisingly, EUR/CHF has fallen further in recent days, and most argu-ments would suggest a further moderate fall in EUR/CHF going forward. The SEK has also weakened signifi-cantly this past week, and EUR/SEK has risen to its highest level since 2001. Global risk aversion and a slowing Swedish economy are good arguments for a weaker krona, but the movement seems somewhat overdone, and we expect some decline in EUR/SEK going forward. The coming week will see interest rate decisions in Australia, the UK and Japan. We expect the RBA to cut by 25bp, though the chances of an even larger cut are close to 50%. We believe the Bank of England will keep the next rate cut until November, though the sharp fall in the PMI this past week has significantly increased the likelihood of a cut. Again, see also FX Crossroads for a discussion on the outlook for the pound. Japan is expected to remain on hold.

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