Weekly Focus

Euroland: ECB to Cut Rates

The German Ifo index confirmed the image of a weak European economy in the past week. Ifo fell from 90.2 to 85.8, which was weaker than even our substantially below consensus forecast. The Ifo index is now at its lowest level since February 1993. Both the assessment of the current economic situation and - more worrying - the expectations index fell. The expectations index normally provides a decent impression of activity in Euroland in three months' time. Meanwhile, inflation is beating a hasty retreat in Euroland, falling from 3.2% in October to 2.1% in November. This must surely extinguish any lingering fear the ECB may have harboured on high inflation.

The key event in the coming week will of course be Thursday's rate meeting in the ECB and the press conference that will follow. There is nothing to prevent the ECB from cutting further: the outlook for growth is very weak and all fears of inflation must by now, as mentioned, have evaporated. We expect this picture to be reflected in the so-called Staff Projections, which will include a historically large downward revision of European growth estimates. The Staff Projections will be an important input to the discussions in the ECB. The ECB has already cut by 50bp twice: first in connection with the coordinated action taken by key global central banks on 8 October, and subsequently at the rate meeting on 6 November. We expect a cut of 75bp this time around, meaning the ECB would have displayed a hitherto unseen level of aggressiveness - so there is a significant risk that the ECB will make do with a cut of 50bp.

Among the other important events in the coming week is final PMI for Euroland. We expect no change compared to the flash estimate, ie, 39.7 for composite PMI. Detailed Q3 national accounts data will also be released for all of Euroland. GDP is expected to show a fall of 0.2% q/q - unchanged relative to the flash.

Key events of the week ahead

• Monday: German Ifo. We expect a fall to 87.0 from 90.2 in October. Expectations index set to fall from 81.4 to 80.5.
• Friday: Flash HICP expected to fall from 3.2% y/y in October to 2.4% in November.
• German national accounts and unemployment and M3 for Euroland during the week.
• Thursday: ECB meeting. We expect a cut of 75bp. Detailed national accounts. GDP expected to fall 0.2% q/q - unchanged vs. flash.
• Final PMI for Euroland during the week. We expect flash estimate of composite PMI at 39.7 to be confirmed

Switzerland: Weaker Swiss Franc, but Uncertainty Remains High

The all-dominating theme in the past week has been the string of new and very ambitious rescue packages. US-based finance giant Citigroup was saved with a capital injection, the US Fed presented a USD 800bn rescue package (this time primarily financed by printing more money) and the European Union presented a number of national and EU-financed fiscal policy easing measures. The market reacted positively to the new measures, and as the benchmark stock indices rose, so the Swiss franc weakened. CHF/DKK is now trading around 4.80 and thus far below the peak of 5.21 seen at the end of October. The FX market is, however, still marked by high uncertainty, and while the magnitude of the actual fluctuations in CHF/DKK has diminished somewhat, the market continues to price in historically large expected fluctuations (implied volatility trades close to 14% for 1-month maturity, see graph).

The Swiss National Bank (SNB) surprised the markets on 20 November by cutting interest rates by 1 percentage point to just 1.00%. This of course prompts the question: what next? Communication from the SNB has been limited, though SNB vice president Hildebrand confirmed in an interview with the Swiss magazine "Weltwoche" that the SNB has downgraded its growth expectations markedly, such that negative growth is now expected in 2009. He also emphasised that the SNB remains committed to preventing the global financial crisis leading to an "extreme" growth scenario. Inflation fears have, meanwhile, almost completely disappeared from the monetary debate, and we expect that the SNB will ease further given the very weak real economic outlook. However, the big question for us is not so much whether the SNB will ease monetary policy further, but whether the money market will normalise sufficiently to permit a credible reduction of the target rate. Since the SNB cut the target rate to 1.00%, 3M LIBOR has fallen sharply and now fixes just 27bp above target after the SNB reduced short rates further - a 1-week repo is now offered at just 0.10%. Thus if the SNB succeed in getting the 3M LIBOR down to target before the Q4 meeting on 11 December, we see a high probability of yet another rate cut.

That the real economic outlook has become very weak was underlined by the leading KOF indicator, which fell more than expected in November to -0.05 from 0.28 in October. Thus the KOF indicator is negative for the first time since 2003 and now suggests negative real GDP growth in 2009.

Key events of the week ahead

• Monday 09:30 - PMI for November
• Tuesday 07:45 - CPI for November.
• Wednesday 17:00 - SNB's Roth speaks in Vezia.
• Thursday 07:45 - Q3 GDP

USA: Moving Through the Darkest Days of the Recession

The US economy has performed very poorly in recent months, with consumer, business and residential spending all contracting - indeed, the credit crunch has made funding scarce for both consumers and businesses. On the positive side, the inflation outlook has improved significantly over the past few months and will work as a super-boost to real incomes. Commodity prices have imploded and the slack in the labour market is building rapidly, meaning that both headline and core inflation are past their cycle peaks. Nevertheless, consumers are currently fighting an uphill battle due to unusually tight funding conditions and a deteriorating labour market. With business and residential investment contracting as well, the economy will remain in recession in the coming two quarters, but we expect Q4 to mark the low-point for growth in this cycle. With the fear of deflation emerging and a further deterioration in the economy ahead, the Federal Reserve is now pulling out all the stops, and we believe it will take the fed funds rate to zero by January and continue to implement full-scale quantitative easing.

We expect the US economy to emerge from the darkest days of the recession as we enter 2009, and that growth will turn moderately positive in Q2 next year. The recovery is, however, likely to be relatively modest by historical standards, as the deleveraging in the financial sector, declining home prices and rising unemployment will continue to weigh on growth throughout 2009. That said, the uncertainty surrounding our forecast is higher than usual. A fiscal boost in early 2009 is on the cards, and this would dramatically change our 2009 forecast. Meanwhile, credit markets developments are also clouded by uncertainty. Importantly, though, risks are not only to the downside (for further details see Global Scenarios - December 2008).

Economic data will continue to look poor in the coming months, and that goes for the round of data due in the coming week as well. ISM manufacturing for November will be released on Monday, and we expect the index to take another dip to 38.1. The US labour market is deteriorating fast, which will also be evident in Friday's non-farm payroll data. We expect a decline of 380,000 in November's non-farm payrolls and a further rise in the unemployment rate to 6.8%.

Key events of the week ahead

• Monday: We expect a decline to 38.1 in the ISM manufacturing index
• Monday: Bernanke speaks on the US economy
• Wednesday: Non-manufacturing ISM set to decline as well - we look for a reading of 42.8
• Wednesday: Fed releases its Beige Book
• Friday: We expect a decline of 380,000 in non-farm payrolls for November, taking the unemployment rate to 6.8%

Asia: Deflation Returning to Japan

In connection with Globale Scenarier, December 2008, which has just been published, we have again revised down our forecasts for both growth and inflation in Japan. For 2009 as a whole, we now expect growth of -0.5% and modest deflation of -0.6%. Hence the risk of deflation will once again appear on the agenda for Japan. The large fall in inflation is due not just to one-off effects from lower energy prices. With a weaker labour market and wage growth that will probably again become negative, it is also likely that core inflation will again turn negative. Therefore there is a real risk that Japan will again face deflation, and this is why we now believe the Bank of Japan (BoJ) will cut its key rate by a further 20bp to 0.1% - most likely at the start of Q2.

In practice this will be a return to the zero interest rate policy, though this will have no great implications for growth. It will, however, make it easier for the BoJ to focus its energy on providing the liquidity necessary to stabilise the financial sector in Japan. The BoJ is already trying to do this, but in practice it has had problems steering the very short money market rates towards the target, which it expresses via its key O/N target rate. Due to the significant liquidity there is in the system, there has been a tendency for O/N market rates to be lower than the O/N target. Thus it would basically make life a little easier for the BoJ if it takes its key O/N target rate further down. The simple solution would be to set the O/N target at zero. As a majority of council members assessed a rate cut of 25bp as too big a cut when BoJ last cut rates, it is more likely that BoJ will once again settle for 20bp.

Given the current very weak growth and inflation picture in Japan, it will likely be quite some time before we again mention rate hikes. There is currently nothing to suggest this will be relevant in 2009. Our best estimate is that it will probably be the middle of 2010 before rate hikes are back on the agenda in Japan

Key events of the week ahead

• China: main focus will be NBS PMI and CLSA PMI for industry in November. Both have recently indicated a pronounced slowdown in industry (see graph).
• Japan: business investments for Q3 on Wednesday - an important input for the revision of preliminary GDP numbers for Q3.

Foreign Exchange: Rescue Packages vs. Economic Data

The past week saw a series of initiatives from the world's central banks aimed at stabilising the situation in the financial markets. On Monday, a rescue package for banking giant Citigroup was passed, and on Tuesday the Fed declared its intention to buy up assets for USD 800bn with the aim of limiting the extent of the economic slowdown. On Wednesday, the People's Bank of China cut interest rates substantially and the European Commission presented its plan to stimulate the European economy. Pulling in the other direction were some horrible data, including the University of Michigan confidence indicator, Chicago PMI and the German Ifo index, which all surprised negatively.

Market focus was naturally directed towards the ambitious measures announced, especially from the Fed: Equity prices corrected from the low point reached in week 47, the VIX index fell below 55, and the price of oil rose above USD 50 a barrel. At the same time, there was a general strengthening of currencies that normally appreciate when risk appetite increases (AUD, NZD and SEK), while counter cyclical currencies such as CHF and JPY (and USD) weakened.

In order to quantify the perception of risk in the FX market, we have put together an index that represents relevant risk factors (see FX Crossroads: It is all about risk, 26 November 2008). In general, movements in the FX market can be related to movements in other asset markets, and so the index is composed of components that capture the uncertainty in the equity, bond and commodity markets. While the index points to a fall in risk aversion in the coming week, the index remains at a historically high level - showing that uncertainty in the financial markets remains very elevated.

The additional financial rescue packages announced in the past week do not cause us to change our basic view on the effects of the global recession and the financial crisis. By injecting capital and providing protection for Citigroup against losses on its loan portfolio, the Fed helped reduce risk in the economy, and thus the past week saw a general strengthening of risky assets and a weakening of the US dollar. We expect, however, that deleveraging and repatriations, primarily by US investors, will continue for some time yet. Together with a weak global outlook and subsequently lower oil prices, this scenario means that there remains potential for USD to strengthen. For the same reason we believe that it is still too early to abandon our "better safe than sorry" approach, and would advise against establishing risky yield-arbitrage positions (borrowing in a low-yielding currency with the intention of placing in a high-yielding currency) at the present time. Thus we are generally positive on JPY, CHF and USD relative to AUD, NZD and SEK.

The week ahead is particularly data-heavy, with activity data and central bank rate decisions in the UK, the Eurozone, Australia and New Zealand. Monday sees the release of the ISM manufacturing confidence indicator in the US, while the US service sector ISM will follow on Wednesday. Non-farm payrolls are due Friday, and are expected to show a further deterioration in the US economy. A pronounced weakening in the economic data is on the cards, and could spark a renewed fall in share prices. This could cause USD to strengthen given the negative correlation with equity markets seen lately.

After its massive 150bp cut in interest rates in November, the Bank of England's (BoE) rate decision will be keenly awaited on Thursday. Like consensus, we expect a further 50bp cut to 2.50%. The market, however, is pricing in 75bp, and the decision is cloaked in much uncertainty - we see the risk mainly to the downside. With the weakening of the pound in connection with the BoE's previous policy rate decision in mind, there could be significant fluctuations in the currency following the announcement. The ECB's rate decision, also on Thursday, will be another focus of attention. Consensus foresees a 50bp cut to 2.75%, while the market is pricing in up to 75bp, which is our expectation. The subsequent comments from the ECB will indicate its opinion of the European economy - we see the greatest risk being a weakening of the euro. Note, though, that the ECB has not previously cut rates by more than 50bp at a time.

Fixed Income: Fed's Printing Presses Roll

Risk appetite and fresh moves from the Federal Reserve have dominated the past week, taking the 10-year US Treasury yield below 3% for the first time for half a century. Yields in Euroland also continued to tumble during the week.

The interest rates paid by US households and businesses have not fallen despite the Fed slashing its rates, which means that traditional monetary policy has lost its power. Taken together with the credit crunch and a US economy deep in recession, this prompted the Fed to turn to a new weapon during the week - "quantitative easing". In this case, it means printing extra money and using it to buy mortgage bonds and fund other loans, such as credit card, car, student and small business loans. This is a very positive step and reduces the chances of the direst predictions for the US economy next year becoming reality.

The market's reaction to the move was much lower US mortgage rates, and this has dragged down Treasury yields in the last few days, with the result that long yields have not followed equities up over the last couple of days. However, we expect risk appetite and the equity markets to return as the main drivers behind day-to-day movements in the fixed income markets in the coming week, which also brings some important economic data stateside and a very exciting monetary policy meeting in Euroland.

The ECB has yet to really cut its rates hard, but has a chance to do something about this in the coming week. We predict a 75bp cut on Thursday, but neither 50bp nor 100bp can be ruled out.

On the economic front, interest during the week will centre on the US employment report and ISM business confidence survey. We expect the ISM index to fall further to 38.1. Unemployment in the US is rising rapidly at the moment, and the employment report will paint a very bleak picture of the US labour market, with a steep drop in employment of 380,000 persons.

In Denmark, attention will focus on the "flex loan" bond auctions, which start up for real in the coming week. Read more about these auctions in the editorial. Also centre stage is the spread between central bank rates in Denmark and Euroland. Denmark's foreign exchange reserves are important in this context, and figures for them will be published on Tuesday. There is also the question of whether the Danish central bank will follow the ECB down on Thursday; we expect so.

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