Euroland: ECB meeting in the light of weak growth indicators and high inflation

It has been an eventful week, with many of the remaining pieces falling into place in the run-up to the coming week's rate-setting meeting at the ECB. The PMI for Euroland as a whole fell quite sharply in June, which suggests only rather weak growth for the rest of 2008. The fall in the Euroland PMI reflects weak PMI figures for Germany and especially France, which were accompanied by a number of other weak indicators. For example, the Ifo index dropped sharply from 103.5 to 101.3, and French consumer confidence fell further to -46 from an already historically low -41 in May.

The coming week is also a busy one. The final pieces to fall into place ahead of the ECB's meeting on Thursday are June inflation, which we expect to be 3.8%, and final PMI data for Spain and Italy.
The highlight of the week is the ECB's rate-setting meeting. At the press conference in June, the bank surprised everyone by clearly signalling a 25bp rate increase to 4.25% at its next meeting. It would be very difficult for the ECB not to deliver the goods now without losing face. Although incoming data since then have almost unanimously painted a picture of a Euroland economy that is cooling very quickly, we do not think they have been sufficiently weak for the ECB to hold its fire. We therefore expect a rate increase of 25bp in July, but we also expect that growth will weaken sufficiently for the ECB not to raise rates further. Note, though, that this forecast is associated with usually high uncertainty. We have not previously seen the ECB raise interest rates when the economy is shifting down a gear. With the expected hike in July, the ECB is showing that it is ready to react if it sees signs of its credibility coming under pressure. Incoming information on inflation expectations will therefore be particularly important in the coming months.

Key events of the week ahead

• Monday: Euroland inflation in June. We expect 3.8%.
• Tuesday: Final manufacturing PMI for the big four euro economies.
• Thursday: ECB rate-setting meeting. We expect a 25bp hike to 4.25%.
• Thursday: Services PMI and composite PMI for Euroland.

Switzerland: Is the high inflation only temporary?

The main event of the week in Switzerland will be the publication of inflation figures for June on Thursday - not least because inflation continuing at a high level will be needed for the SNB to respond to the ECB's expected interest rate hike in July. Inflation has been gathering pace in Switzerland since mid-2007, and hit 2.9% y/y in May, its highest level since 1993. However, the latest rise in inflation has been primarily driven by higher food and energy prices, and can therefore to some extent be expected to be temporary, assuming that oil prices do not continue to rise. The SNB has in fact communicated that it considers the current breaching of its inflation target to be only temporary, and its latest projections indicate that inflation is expected to drop back below 2% in Q2 next year.

However, the producer and import prices (PPI) for May released on 20 June were not exactly encouraging. The increase in PPI was 3.9% y/y, slightly above the consensus expectation of 3.6% y/y. While some of the increase was driven by higher import prices due to higher oil prices, the data also showed that producer prices actually rose more than import prices. Looking at the components of producer prices, these generally indicate increased domestic price pressure, as was also clear from the SNB's latest core inflation data. Nevertheless, the second-round effects from high oil prices can be expected to be relatively modest, as is also assumed in the latest forecasts from the major Swiss research units.

For example, the past week brought an updated economic forecast from the State Secretariat for Economic Analysis (SECO). Like the SNB, SECO expects inflation to drop back early next year. This is also our main scenario, as favourable base effects coupled with dwindling domestic demand can be expected to pull down inflation. However, risks are on the upside. We still expect inflation to remain lower in Switzerland than in Euroland, which will put downward pressure on EUR/CHF in the longer term. In the short term, though, it will be the central bank's reaction to the high rate of inflation that dominate. If the ECB hikes in July and the SNB does not follow suit in September this would (other things being equal) result in temporary pressure on the CHF.

Besides the inflation report, the coming week brings the PMI figures for June (SVME). The Swiss PMI has closely mirrored movements in the KOF leading indicator, and has trended down since autumn 2006. The KOF indicator for June was published on Friday, and showed a drop from 1.08 to 1.01, which is a deceleration compared to the falls in previous months.

Key events of the week ahead

• Tuesday brings the PMI for June.
• Thursday brings the week's most important data from Switzerland - June inflation figures.

UK: PMI data - further weakness?

The past week has been more of the same. The CBI distributive trades survey rebounded a little on reported sales, but expected sales fell back. So overall there is still a very large divergence between actual retail sales showing sales up 7% while a range of surveys indicate retail sales growth of 1%. Fundamentals are very poor for UK consumers, with rising inflation, a weakening labour market and declining house prices. The woes in the housing market were yet again highlighted this week with the release of BBA mortgage approvals, which were down 56% y/y, declining to the lowest level since 1997. Adding to the headwinds are rising signs that Euroland - one of the UK's largest export markets - is slowing more rapidly. Hence exporters will likely face a more pronounced trimming of order books than was initially anticipated.

The weak economy has also been highlighted by soft PMIs, and the next is scheduled for release in the coming next week. The service sector, in particular, has shown marked weakness (see chart). PMI price components are rising strongly, however, adding to the Bank of England's dilemma. At the moment, the bank is not in a position to support growth due to high inflation pressures. Inflation went above 3% last month, triggering a letter from the MPC governor Mervyn King to the chancellor of the exchequer to explain why inflation had broken the 3% upper limit of the MPC's range of 1-3% (target at 2%). After a period of pricing up to 75bp of hikes over the next year from the Bank of England, the market has now scaled back its expectations to less than 50bp. Financial jitters and weak growth data are again leading to lower yields, and we think this could continue. We also continue to look for a weakening of GBP vs EUR.

Key events of the week ahead

• Monday: Nationwide house prices
• Tuesday: PMI manufacturing likely to fall further
• Thursday: PMI service is also on the decline
• Thursday: Bank of England credit survey should be interesting. Banks may have tightened credit conditions even further.

USA: Manufacturing faces further slowdown

The Federal Reserve rate meeting set the agenda for the past week. For the first time since August last year the US central bank did not cut interest rates, which thus remained at 2%. At the press conference afterwards, the Fed noted that the economy did not appear as distressed as previously feared. At the same time, increasing concern was expressed about the high level of inflation and inflation expectations. Overall though, the tone was relatively balanced, and thus did not indicate a hike anytime soon. Clearly the bank remains very uncertain about the prospects for both growth and inflation. While the chances of a rate hike in the near term have diminished as a result of the meeting, the market is still pricing in a more than 50% probability of monetary policy tightening in September (see Flash Comment: FOMC - Neutral, with rising inflation concerns).

We still believe that rates will be left unchanged for an extended period, as the general picture of a stagnating economy does not look likely to change in the foreseeable future. Indeed, this picture will probably be re-inforced in the coming week by manufacturing ISM and the jobs report. So far, the manufacturing sector has remained relatively buoyant, held afloat by low inventories and solid export performance. In recent weeks, however, there have been a number of signs suggesting that the sector is on the edge of a more pronounced slowdown. Local manufacturing indices for June, for example, have so far fallen. The four indices currently available, for New York, Philadelphia, Richmond and Kansas, together indicate an ISM at 43.4 in June versus 48.6 in May. Furthermore, the latest order data demonstrated a deterioration in the ratio of inventories to sales for consumer durables. That said, the ISM has tended to surprise positively in recent months, which is why we expect a more moderate fall to 48 (consensus 49). Friday's jobs report is expected to present a largely unchanged picture of the labour market, with a modest decline in employment of about 50,000, and a temporary dip in unemployment to 5.4% after last month's sharp increase.

Key events of the week ahead

• Monday - Like consensus, we expect the Chicago PMI to fall to 48.0 from 49.1.
• Tuesday - ISM expected to fall to 48 in June from 49.6 in May. We are a little below the consensus forecast of 49.
• Thursday - Jobs report will show employment falling by 50,000 and unemployment dipping temporarily to 5.4 %.
• Thursday - Service ISM for June almost unchanged at 51.5.

Asia: Japanese inflation jumps as growth stalls

A string of economic data in the past week suggests, on the one hand, that inflation is rising more than expected and, on the other, that GDP growth will stall in Q2 after surprising positively in previous quarters.

Inflation excluding fresh food rose to 1.5% y/y in May from 0.9% y/y. Some of this jump was due to the government reintroducing a petrol duty that was temporarily lifted in April. The increase in petrol duties explains around 0.3 percentage points of the increase in inflation. Preliminary inflation numbers for the Tokyo area in June suggest surprisingly strong price increases on food. Together with increasing energy prices, this means that inflation in June could reach as high as 1.9% y/y. Thus, a breach of the Bank of Japan's target for price stability (0%-2%) in the coming months can no longer be ruled out, in contrast to what we had previously assumed.

It is first and foremost the increasing rate of inflation that means the outlook for private consumption is very weak in Japan. Rising inflation coupled with slowly falling employment means that overall real income growth is currently less than -1% y/y, as can be seen in the graph below. By way of comparison, real incomes were growing by more than 0.5% y/y in early 2008. Weak real income growth means we now expect a considerable fall in private consumption of -0.5% q/q in Q2. Given that export growth has also slowed sharply, GDP growth looks set to slow significantly in Q2. We currently forecast zero growth in Q2 (revised down from 0.3% q/q), but negative growth can certainly not be ruled out.

In light of the outlook for a significant slowdown in growth, we believe that the BoJ will continue to have a relaxed view about the recent rise in inflation. Furthermore, core inflation (excl. energy and food) is still just 0% y/y, and there is as yet no sign of second-round effects from rising energy and food prices. While inflation may rise more than we previously expected (and temporarily breach the price stability target), we do not believe it will have any noticeable effect on monetary policy. The BoJ may begin to focus a little more on inflation expectations, but we still expect that it will not hike interest rates until H2 09.3

Key events of the week ahead.

• Monday sees the release of Japanese PMI manufacturing for June and housing starts for May.
• On Tuesday, the Bank of Japan will publish the important Tankan survey for Q2. Business confidence is expected to deteriorate significantly.
• Also Tuesday, Chinese manufacturing PMI for June. So far there has been no suggestion of a slowdown in industrial production,3

Foreign Exchange: Dismal maybe, boring never

If you have ever wondered why economics is regularly referred to as "the dismal science", just cast a glance over the data of the past week. We are currently witnessing an unheard of collapse in consumer confidence (in Denmark, consumer confidence fell to its lowest level since 1999, in the US to the lowest level since 1992, in New Zealand to the lowest level since 1991, and in France to the lowest level since 1987 - to name just four). At the same time, purchasing mangers' expectations (PMI and ISM) show that industry is now contracting in the US, Euroland, the UK and Japan. Further, US housing market indicators this week show that the situation here continues to deteriorate. On top of all this comes a jump in inflation. This is perhaps most visible in countries such as Vietnam (consumer prices up 26.8% y/y this week), Iceland (12.7% y/y) and South Africa (11.7% y/y), but inflation is also making its mark closer to home: Belgian inflation is running at 5.8% y/y, the highest rate since the mid-1980s. Central banks are, of course, under pressure from rising inflation, and Norway, Poland, Rumania, Mexico and Taiwan all hiked in the past week.

The events of the past week lie well within our strategic framework centred on an economic slowdown and a financial crisis. However, as we wrote two weeks ago (see An era gone by), inflation must now be added as a third leg, which does not make the challenges any easier: inflation erodes consumer purchasing power, and central bank hikes tighten the liquidity cycle above and beyond that resulting from banks tightening their lending standards. We definitely see the glass as half empty rather than half full.

On FX markets, the euro is setting a pace that few other currencies can match. The top performing currency of the past week was HUF, which rose to its strongest against EUR since 2002. A shift in interest rate expectations that benefited Hungary was part of the story, but even the central bank's decision to leave rates unchanged this week could not prevent further strengthening. However, the Hungarian economy does not impress either in terms of strength or balances, and we do not expect the rise to be sustained. In second place was NOK. Norges Bank's rate hike and impressive fundamentals make the Norwegian krone a much more likely candidate for further appreciation. After these two, EUR came in a solid third. Bottom of the league were KRW and NZD, both falling around 2% against EUR. USD and JPY did not do much better. ISK started the week with a sharp fall to a new all-time low, but later corrected.

The euro appears to be drawing most of its strength from a shift in relative rate expectations, but an indirect effect from rising oil prices is also at play. As we show in the current FX Crossroads, the latest rise in oil prices left behind it a risk of EUR/USD and EUR/JPY increasing, and USD/CAD and EUR/NOK falling. EUR/USD should be able to rise further in the coming week, towards 1.5850 at first, though technically a break here would indicate a new top around 1.63. The ECB meeting on Thursday 3 July could be critical: Trichet has said several times that one cannot expect a series of rate hikes, but so far neither the fixed income nor the FX markets have listened. Should he really carve this out in stone, a downward correction may result. The strength of the euro was also reflected in an increase in EUR/JPY to a new record high. The movement is in line with both rates and oil prices, but does not sit well with falling equity prices. We do not expect the fall in JPY to be sustained, and currently recommend selling USD/JPY.

Fixed Income: Financial fears are back

Inflation has been name of the game in bond markets for some time. Further increases in oil prices, inflation rates close to 4% and rising inflation expectations in several countries shifted focus dramatically from financial fears to an inflation scare. The ECB reinforced this shift when they signalled a July hike. The change in dynamics is illustrated in the chart below, which shows how close bond yields were correlated with equities when financial fears dominated. The "decoupling" of the two markets happened when inflation fears took over and hit both markets. Residuals were very negative until March, as risk appetite drove yields much lower than was warranted by growth. This rapidly turned around as inflation fears gripped the market and sent yields to much higher levels than explained by the growth picture.

More recently, however, financial fears have resurfaced and reached a point where they could no longer be ignored by bond markets. Rumours about US automaker Chrysler having financial problems and renewed fears of rising banks losses have taken a firm grip on the market in recent days. This has to some extent been reinforced by very soft Euroland growth numbers (PMI, Ifo, consumer confidence) - raising fears of a pronounced slowdown - and by the Fed being less hawkish than expected. Worryingly, oil prices are not showing any signs of levelling off despite all the bad news. Oil prices hit a new high yesterday above USD 140/bbl. Hence the inflation picture is not likely to improve - and could even worsen. German CPI data point to a rise in Euroland HICP to 3.9% in June, and perhaps breaking the 4% mark in the coming months if oil prices remain elevated.

This development heightens the dilemma of the ECB. The bank has signalled a rate hike next week - which we think they will deliver, despite the recent jitters in the market - but the question is what happens after that. We think it is fair to price in some chance of a further hike, but the current pricing of close to 3 hikes seems a little too much.

In the short run we also see scope for a further decline in risk appetite and more weak growth data, which will put a further dampener on yields levels. The big joker in the pack is inflation expectations. The ECB has made it clear that it will not tolerate a rise in inflation expectations - hence, if this happens it could ruin the outlook for slightly lower yields at the short end of the curve. The longer end might still manage to come down a bit, though, as more ECB hikes could lead to a further twisting of the yield curve, as seen recently.

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