Economic Outlook: The ECB has Rattled the Sabre

This week's highlights

There are indications that for the first time in more than twelve months the ECB will raise interest rates at the meeting on 3 July. It is not 100% certain that it will raise interest rates by 0.25 percentage point, but it will surprise us and many more if the bank holds interest rates. If it does, there is no doubt that it will lose credibility and there will be widespread uncertainty about the ECB's line and communication.

However, there is one little detail which is different from when the bank has previously indicated a hike in the subsequent month. Usually a hike is indicated through the expression 'strong vigilance' while 'monitor very closely' is used when interest rates will not be raised in the subsequent month. After the last meeting, the ECB used the expression 'monitor very closely' but added that it was in a 'state of heightened alertness'. A reflection that the usual rhetoric did not quite cover the bank's need to formulate whether it should raise interest rates at the next meeting or not.

However, we assess that the ECB will raise interest rates due to

• the wording in the last press release combined with statements made at the subsequent press conference
• comments from several members of the Governing Council during the month
• Trichet's testimonial to the European Parliament

The most interesting at the press conference will be to see how the bank rewords its expression 'in a state of heightened alertness'. This includes its rhetoric about whether one hike is sufficient or there is more to come. But usually the ECB only indicates interest-rate changes one month ahead.

On the basis of Trichet's comments in his testimonial to the European Parliament, we assess that this interest-rate hike should not necessarily be seen as the start of a new series of interest- rate hikes. The bank will not just note that inflation expectations are rising since it will be prepared to react with further interest-rate hikes.

The bank noted in this connection that unit-wage costs and service prices have begun to increase, and this will give rise to concern at the ECB since it is something to which it attaches great importance. Whether the bank will raise interest rates more than once - which we consider highly likely but do no expect - will be very dependent on economic indicators and inflation expectations. Moreover, the ECB will focus on the development of wages. In this connection, it will pay attention to whether countries which can compensate wage earners with high wage increases via labour agreements will actually do so. The ECB has admonished these countries not to do so. Focus will also be on the labour talks in Germany in the autumn.

This week's other highlights

• The US: job report, ISM Manufacturing and service
• The euro zone: consumer prices
• Japan: Tankan report
• The UK: PMI and house prices
• Sweden: Monetary-policy meeting at the Riksbank

Monday

The euro zone: consumer prices, preliminary

Consumer prices are high and much too high for the liking of the ECB. Moreover, the high rate of inflation is deadly to growth in consumer spending since it erodes households' purchasing power. In May, inflation rose to 3.7% y/y. We expect inflation for June to be a tad higher or at the same level.

Japan: Tankan report from the BoJ, Q2 (1 July)

The Japanese economy is slowing down. We expect this to be confirmed through further declines in the Tankan report which is an extensive quarterly business sentiment survey based on data from more than 10,000 businesses.

In the first quarter, the current index (of manufacturing/ large businesses) fell to 11 from 19 while the index of expectations fell to 7 from 15. We expect both indices to fall further since slower domestic demand and slower global growth burden businesses just as rising commodity prices put pressure on corporate profits. Although both indices are at the lowest level in four years, they remain in positive territory and there are no prospects of recession-like growth rates.

In the first quarter, businesses said planned investment would be reduced by 1.6% in the current financial year which is the lowest level since the recession in 2001/2002. However, there are usually relatively large declines in the first quarter when businesses are still considering the targets for the new financial year. In the second quarter, we therefore expect a minor rise in planned investment. Machinery orders which are usually a good indicator of corporate investment at 6-9 months' term show moderation. This is altogether not very positive for investment which has long been an important growth engine in Japan. The level is, however, still significantly higher than during previous recessions.

Tuesday

The US: ISM Manufacturing - June

ISM is the nationwide sentiment indicator for the manufacturing industry and gives a reasonable indication of the development in industrial production and GDP. This time the financial markets will focus on whether ISM still signals that the US avoids recession. ISM is also used as a recession indicator since traditionally it falls down to around 41 - 42 during recessions. So far, it has only signalled weak growth but not recession. In May, ISM rose to 49.6 from 48.6 in April.

We expect a fall in ISM in June, which is due to the following:

• Our ISM indicator signals that ISM may fall a few points in June
• There is again turmoil in the financial markets which may pull down ISM
• Oil prices continued to rise from May to June and together with falling house prices and rising unemployment this strains demand
• The sentiment index of small businesses has fallen considerably more than ISM. They are notably bearish about sales
• New orders in the manufacturing industry rose solidly until May. However, part of the increase can be ascribed to price rises.

In addition to the index, focus will be on new orders, employment and the price index. Notably the price index, which is at a very high level, will attract attention.

The US: vehicle sales - June

Vehicle sales from producers are interesting due to high petrol prices (above USD 4 a gallon) which have already prompted Americans to reduce their driving. Rumours have it that there is some risk of a relatively sharp fall in vehicle sales although it has already fallen markedly. Notably the American car producers are hit hard by the rising petrol prices and tightening of credit standards.

Vehicle sales for May fell to 14.6m after the sales were just below 17m in 2007. The sales are the lowest they have been since June 1998. Although sales have already fallen sharply, buying a new car is something consumers postpone during difficult times. Thus we expect a further decline in vehicle sales in June.

The euro zone: unemployment - May

The unemployment rate was unchanged over the past three months while April showed a fair rise in the number of unemployed since more than 60,000 lost their jobs. However, we are somewhat careful about saying that it is already a trend change since data are affected by seasonal swings. It is important to watch developments in the labour market since a turn in the labour market is something which can put a damper on wages and the risk of second-round effects and thus lasting high inflation. A budding rise in unemployment will also put a political pressure on the ECB if the bank indicates continued interest-rate hikes.

Germany: unemployment - June

As the economy has slowed, we have seen signs that this is beginning to take hold in the labour market. Since the turn of the year, the fall in unemployment has been reduced month by month. May was the first month when unemployment rose since it began to fall in earnest in early 2006. The rise should, however, be taken with a grain of salt since it is influenced by seasonal factors. But the unemployment rate has now been unchanged for three months, and in our view this is a signal that the rate is close to the bottom.

The UK: PMI Manufacturing - June

In May, PMI Manufacturing fell to 50 which is the lowest it has been since July 2005. The index thus points to zero growth in the manufacturing industry. Most of the sub-indices fell whereas the index of sales prices rose to the highest level in the history of the index. PMI Manufacturing thus indicates slower growth combined with higher inflationary pressure.

We expect PMI to remain week over the coming months. The order indices in the CBI survey of the manufacturing industry and PMI for May point to unchanged or a slight fall in production.

The UK: house prices - June

According to Nationwide, house prices have fallen in the past seven months and the fall in May of 2.5% m/m was the sharpest fall in the history of the series. The annual rate of increase is currently -4.4% compared with 10.5% in May last year.

Most indicators show that the housing market is likely to show weakness for some months yet, with the rise in house prices slowing further. Among other things, the ratio between housing sales and the stock of unsold houses in the RICS survey - which is a good indicator of future house prices - is still falling, and the number of mortgage loans used for home purchases has fallen to an all-time low since the start of the series in 1993.

Thursday

The US: job report - June

As usual, employment is the absolutely most important indicator to the financial markets, because employment is taken to give a good indication of the state of the economy. Interest has been whetted because unemployment rose by 861,000 persons, the biggest rise in 33 years. Unemployment rose from 5% in April to 5.5% in May. We expect a small fall in the unemployment rate in June.

The employment rate is one of the indicators which have signalled that growth is slow, but that the economy is not in recession. Employment has fallen by 'only' 55,000 a month over the past three months. The fall in employment is concentrated on the usual cyclical sectors such as construction, the manufacturing industry, trade and transportation as well as business services. The public sector and the education and the health-care sectors are continuing at the usual pace.

We expect the employment situation to deteriorate over coming months. This is confirmed by the fact that most indicators signal a sharper fall in employment. We expect a fall in employment of about 80,000 in June, but we still await a number of indicators which are not released until next week.

Jobless claims fell by 13,000 between the two collection weeks (when employment data were collected). This points to falling employment. ISM's employment index for the manufacturing industry remained at its lowest level in June, which signals a bigger fall in employment in the manufacturing industry than during the preceding months. ISM's employment index for the service sector, of which only data for May are available, fell to 48.7. This indicates a small fall in employment in the service sector. ISM's total weighted employment index points to a fall in employment of 75,000. The small companies report the lowest number of jobs vacant since mid-2003.

In the construction sector, employment has fallen, but construction work has fallen more sharply still. In our view, there is a surplus of 300,000 skilled workers in the construction sector. Also, there are signs that corporate construction is falling. This means that there are prospects of a sharp fall in employment in the construction sector.

The surge in unemployment was due to the fact that a very high number of young people left school. This apparently happened earlier than usual, and it is thus probable that the unemployment rate will fall again. This should not be regarded as a signal that the labour market has improved.

Focus will also be on the development in wages, since there is much focus on inflation. The wage increase in May was 0.3% and 3.5% y/y. The general rise in unemployment is expected to lead to a lower rate of wage increase and hence to weakening inflationary pressure from the labour market.

The US: ISM Service - June

The sentiment indicator ISM service is important since the service sector accounts for 90% of employment and is thus by far the most important part of the economy. ISM for the service sector was largely unchanged at 51.7 in May (52 in April). At 51.7, the number was in fact surprisingly high in view of the fact that it is higher than the level during the recession in 2001, and consumers are under severe pressure. The service sector is relatively exposed to the consumers, and this ought to make for a weak reading of ISM for the service sector.

One explanation may be that the consumers have received their cheques, and this may have lifted consumption. On the other hand, consumers are under severe pressure, turmoil has returned to the financial markets, the oil prices and long bond yields have risen. We expect this to cause a fall in the ISM for the service sector in June.

In addition to the overall index, there will be special focus on the employment index, because employment in the service sector is one of the factors that support employment.

The euro zone: monetary-policy meeting at the ECB

See This week's highlight.

The UK: PMI service - June

PMI service fell in May to 49.8 and thus went below 50 for the first time since March 2003. This means that PMI service is currently indicating a setback in the service sector. The subindices showed that activity indices fell, while the price indices, as has been the case these past few months (also for PMI Industry) rose to a record high. So also the service sector is showing clear signs of considerably slower growth in combination with a stronger inflationary pressure.

We expect PMI service to remain week over the coming months. Admittedly, the actual retail sales have shown an unusually high rise, but most surveys and indicators point to lower consumer spending, and our view concurs with this. The slowdown in the housing market will also tend to keep down PMI service.

Sweden: monetary-policy meeting at the Riksbank on 3 July

The sharply rising inflation rate and slowing growth put the Riksbank into a dilemma. We expect that fears of inflation win the game, and that the Riksbank chooses to raise interest rates by 0.25 percentage point. We admit that the decision could go either way, and that the Riksbank may choose to buy time by turning more hawkish and raising the projected interest- rate curve. The Riksbank will also release a new monetary policy report. We expect the report to raise its estimate of the inflation rate. Consumer prices and policy rate

The inflation rate has definitely risen faster than expected by the Riksbank, and it has yet to peak. It is chiefly rising food and energy prices which lift the inflation rate, but there is also underlying inflationary pressure due to the rising rate of wage increase, expectations about higher inflation and low productivity. Furthermore, if inflation remains high over a long period - even though it has increased due to temporary effects - it will increase the risk of accelerating wage increase and inflation expectations. This is obviously worrying the Riksbank and prompts us to expect a last interest rate increase, although economic growth is definitely slowing down.

Friday

Germany: order inflow - May

The German order inflow has shown serious signs of weakness lately and has been falling for the past five months. It is mainly export orders which have pulled down the order intake, whereas domestic orders are better than expected. The order intake of the PMI showed a heavy fall in May, but a corresponding rise in June, while stocks are almost record high. We expect the order intake to change and rise slowly in May. This is rather because we see a need for a small correction after recent months' fall and the slightly better PMI.

Jyske Markets - FX Research
http://www.jyskebank.dk/finansnyt

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