Thursday, January 10, 2008

Reality Check at the ECB?

By Claus Vistesen

Cross-posted from Alpha Sources

Last time I did a big check-up on the Eurozone was when I scrutinized the Q3 GDP numbers which came out quite impressively at 0.7% q-o-q. Today, we learn that these figures were revised upwards to an even more impressive 0.8%. At the time I pointed out, as did the majority of other commentators, that while the Q3 figures were very sound it was not a general cause for optimism as general economic momentum is destined to drop as we moved forward. As the economic data has been steadily rolling in then in late November I feel more than vindicated on my analysis. Goldilocks is dead I am afraid since there was just not, at any point, enough honey in the pot to go around. I promised that I would come in with a a general state of play for the Eurozone in 2008 and I intend to keep my promise. However, the GEM team's inhouse data cruncher Edward has already beaten me to it in terms of accounting for the trajectory of the data as we press on. His general Eurozone piece can be found here accompanied by seperate pieces on Germany, Italy, and Spain. There are lots of details but the general message remains clear; a severe slowdown is on its way and potential risk events loom to make it an outright recession.

Turning towards the well known topic, for the readers of this blog, of ECB watching you would think that all this economic doom and gloom would begin to sink in even at the ECB towers in Frankfurt. Well, I maintain my view that it will at some point but as always the devil is in the detail. Basically, tomorrow's meeting at the ECB plots almost the exact same situation as it did the last time. The trend of new economic data seems to be subject to the perpetual foregone conclusion at this point and today we got another slew of incoming flak pointing towards how the Eurozone is entering new and more dark times.
(From Bloomberg)

German industrial production, exports and retail sales unexpectedly declined, suggesting growth in Europe's largest economy is slowing.

Production fell 0.9 percent in November from October, the Economy Ministry in Berlin said today. Sales abroad, adjusted for working days and seasonal swings, slid 0.5 percent from October and retail sales dropped 1.3 percent, the Federal Statistics Office in Wiesbaden said.
The German economy is losing momentum as a stronger euro makes exports less competitive and near-record oil prices drive up inflation, leaving households with less money to spend. German Finance Minister Peer Steinbrueck said today the government may cut its 2008 growth forecast.

Now, risks loom all over the place in the current environment but the points above sort of sum up the locus classicus of a Eurozone wide slowdown in the sense that if Germany begins to tumble then we can be sure that it is serious. Of course, as I have pointed out before Spain remains important here since the high growth rates experienced by Spain in the past years have been tantamount in pushing up Eurozone wide growth on the margin. However, as many will be at pains to point out this is not exclusively about economic momentum since inflation is also remaining stubbornly high which, as I said, brings us right smack back into the point that nothing essentially has changed since last time. So, will this prompt the ECB to shift course come tomorrow? As for the actual movement in the refi rate I don't think so but with a EUR/USD still flying high tomorrows meeting could still bring ripples through the market place in case that Trichet´s discourse changes even slightly. In this way, we can sum up the important points for tomorrow's meeting ...

  • A holding operation is a certainty I think. Clearly, the ECB cannot raise rates but with inflation where it is I don't think that the ECB will shift its stance that quickly. Remember the point about aversion towards rapid shifts in decision sentiments predominant among central bankers. However, if Trichet changes his discourse and if consequently the general growth outlook is emphasised I think we can expect a change in bias over the first half of 2008 which will see the ECB come down from its current 4% already in H1-08. I content that the Eurozone may still muddle through but the risks are mounting that this will not be the case. Furthermore, fundamentals rule! 1) The ECB has basically raised rates all through the period where it now seems that the cycle was turning. 2) Many Eurozone countries cannot provide fiscal stimulus; quite the contrary in fact. 3) I believe in re-coupling and not de-coupling. Emerging markets are beginning to take on their part of the load but with the US slowing and financial markets in turmoil specifically hitting housing markets it was bound to affect Europe in general.

  • Where goes the EUR/USD then? Good question and I imagine that many a FX trader is having a 'to be or, not to be' moment in deciding how to play it. During the last couple of days' sessions the FX markets have been fairly calm with no major swings in the major crosses. With both the ECB and BOE deciding tomorrow we could get into choppy waters which opens up the potential for some interesting plays but also as always some burnt eyebrows. For the record I see the EUR/USD going down from its current level at 1.47, especially on a long term horizon over the course of 2008. The question is whether we need to break 1.50 before the reality sinks in. I don't think so but with people talking about a 50 bps cut by the Fed come next meeting anything can happen really. As for concrete positions I am positioning myself with my funny money portfolio for a slide in EUR/USD tomorrow (but my stop is fairly tight).

  • Eastern Europe? Could Trichet mention Eastern Europe tomorrow? I would seem strange but my feeling is that this is now set to crack at least in some of the countries. As such, the whole Eastern European situation could very well spill-over into the Eurozone through transmission mechanisms from Germany/Italy to Eastern Europe as well of course those famous Austrian/Swiss banks who have been supplying loans denominated in Euros and Swissies. In general on Eastern Europe you should not miss Edward's recent piece on Estonia which convinces me that this is about to go. The only question is whether we will see an orderly slowdown which I certainly hope but if currency speculation and runs on the pegs start to float on the jungle drums it could get out of hand and this would require the ECB to take action I think. Yesterday evening I updated my charts on Lithuania and despite a rather dubious spike in Q3 GDP growth (I simply cannot find the 5.2% figure in the q-o-q break up figures) I don't like what I see, especially on the labour market where the job vacancy ratio is beginning to signal one of those 'does not compute' (i.e. we have no more people!) moments. Finally, we need to consider which one of Eastern Europe's economies that is likely to (potentially) go first, as I noted recently in a comment over at Saxo Bank's Investor blog in the context of whether one or many of the CEE currencies would outperform the Euro in 2008 ...

Basically, we are in the stages of a serious correction amongst one or more of
the Eastern European economies. Hungary looks to be the main candidate for a
crash since they are floating against the Euro (but don't for one minute take
your eyes of off the Baltics either). Basically they are entering a recession
but cannot cut rates since this would tank the Forint. Well, this may happen
anyway and then I am afraid that the US subprime debacle will look like a trip
to Disney Land compared to the number of household busts we are going to
see. Basically, a very large amount of CEE households have unhedged
cross-currency liabilities in the sense that they have Swiss or Euro denominated
loans often transmitted with Austrian banks as intermediaries. Now, I don't need
to spell out what happens to their balance sheets if the domestic currencies
take a hit eh? Well, this does not of course mean that money cannot be made by
the timely investor in the sense that fundamentals are not the only driver of
this but still ... watch out because the potential downside is like an abyss
here. Especially, watch out for the Leu and the Forint since these two are the
primary floaters against the Euro which look very bad and so will bear the brunt
of the initial correction. Then of course we may see some of the pegs coming
loose etc.

Ok, this was an appetizer ... will come in with a more structured
view on the Eurozone on the back of tomorrow's ECB meeting. Moreover, will also
present my update charts on Lithuania soon as a proxy for the general
development in Eastern Europe (mainly the Baltics of course). As a final point I
want to move in on a point which came up recently in the context of my coverage of Japan. As such, I really do not want to come
off as the econsphere's number one Dr. Doom. I call them as I see them and being
a macroeconomist I naturally focus on the general environment which I am sure
you will agree is looking rather wobbly at the moment. But please do not
misunderstand this as a call that I don't think money can be made in any given
market. It can and I am a firm believer in rolling up your sleeves and get on
with it. More generally, there is also the point that I might be wrong :) and
especially with respect to a call on the Eurozone as an aggregate economy I
would say that this is pretty difficult although I am convinced that Italy will
experience a recession in 2008.

Ok, on we go and happy trading if that is your game.

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