Euro-zone Chartbook - Q4 2006

We currently believe that the ECB is going to hike rates again before the end of the year. But, with the onset of a rise in the German VAT (value added tax), there are concerns about German consumption and the impact this could have on Euro-zone consumption as a whole. This means that the ECB is likely to slip into a more data dependent mode with the onset of 2007.

We expect the VAT hike to have a slowing impact on growth and to engender some inflationary pressures (Exhibit 8). We also expect inflationary pressure coming from potentially higher cost of diesel at the beginning of the year, stemming from the U.S. conversion to European diesel, which has lower sulfur content.

Euro-zone unemployment still remains high at 7.8 percent (Exhibit 4). Even though there has been some improvement in the unemployment rate in recent quarters, the retail space remains somewhat stagnant (Exhibit 5).

In contrast to the retail sector, industrial production has improved in the Euro-zone, and remains a source of economic growth. (Exhibit 6). The higher cost of capital, however, is likely to engender some slowing in this space next year.

With the onset of the Fed's holding of rates at 5.25 percent, the euro has strengthened against the greenback (Exhibit 7). This strength could show volatility depending on market data, but we believe that the dollar is likely to weaken against the euro on trend.

The ECB is likely to hike its main policy rate 25 basis points before the end of the year, while the Fed is likely on hold. For 2007, we see the ECB on hold and the Fed cutting the Fed Funds Rate by 25 basis points in the first quarter. As such, interest rates are likely to be fundamentally dollar-bearish, especially with the backdrop of an extremely wide U.S. current account deficit (Exhibit 8).

Exhibit 1

Exhibit 2

Exhibit 3

Exhibit 4

Exhibit 5

Exhibit 6

Exhibit 7

Exhibit 8

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