Thursday, February 07, 2008

Walls Closing in on the ECB?

by Claus Vistesen

Cross-posted from Alpha Sources

It is early morning in Austria and I thought that I would move in with some quick observations on the forthcoming ECB meeting and subsequent tête-à-tête between Trichet and the markets over just when and where the ECB will blink and lower those rates. This may of course be a question of whether the ECB will move or not but my feeling is that at some point the hitherto strong dam built of vigilance and a mandate to keep inflation at bay will crack. In this way and if we look to the most recent slew of data ticking in on the screens in Frankfurt the dilemma has not exactly grown smaller. We learned yesterday that secondary inflation pressures measured by the PPI rose to an all time high posting a nasty 4.5% y-o-y reading in December. Of course this needs to be taken with a pinch of salt since if we look at the rebased figures (where 2000=100) the increase seems much smaller and essentially amounts to a stagnation. However, at the ECB this is still not going to go down well with the hawks. Moreover, the M3 gauge stayed stubbornly high in December 07 posting an increase of 11.1% y-o-y. This constitutes a clear slowdown from November 07 but if you are operating with a target of 3-4% this figure is likely to cause all kinds of alarm bells to sound. I have on many occasions doubted the validity of the M3 as a policy tool and most specifically one which should have a specific target assigned to it. And as the days go by I feel more and more vindicated. A simple observation will do the trick I think. What good is a measure of de-facto monetary expansion when the gauge is running 317% above its target (3.5%) at the same time as the economy seems to be entering a recession in key sections and regions? Moving into a bit of details we also observe that loans to households on a broad scale seem to be trending down which is only to be expected in the current environment and it only remains to be seen how far this damned credit crunch will go.

That was the most recent inflation and monetary readings then and even though these are bound to command much attention as the council convenes around the roundtable in Frankfurt there is a flipside to all this and that is the steady trickle of economic news and data which only seem to confirm that the Eurozone is entering an environment where recession is likely to be felt in key parts of the 13 country economic zone. Where to start then? Well, why don't we start somewhat off the chart in the current context and look at the US where the service sector ISM took a veritable plunge this Tuesday. The ever readable Macro Man (here is to hoping that he will get his British passport soon) presents a nasty graph which shows the overall severity of the situation. I am merely pointing to the US situation in order to indicate where I stand in the whole de-coupling/re-balancing debate and thus give a very crude picture as to how we can expect the global economy to fair as we move forward in the immediate future. Turning to the European data this week must surely be one which has made many a wrinkle form on the foreheads of the economic analysts and observers of the Eurozone. News from the three key sectors in the form of retail, manufacturing and ever so important services indicated what we, at this point in time, already know namely that the slowdown is coming in fast. The only questions left unanswered will be the extent to which this will result in a recession and subsequently in which countries? Sadly, we will have to wait just a bit before these questions can be tested. To boot it all, we have the most recent news indicator from February which showed how European investor confidence dropped to a 2 1/2 year low.

Apart from this very general data review I have another couple of important points I want to note. First of all, the situation in Hungary is looking more and more like a de-facto run on the Forint and given the underlying issues I am not at all happy by the ways things are moving. Consequently, we get the following from the Royal Bank of Scotland Group Plc (via Bloomberg) ...; also chimes in.

Hungary's forint may fall to an all- time low against the euro in 2008 as appetite for emerging- market assets wanes and the country's economic outlook worsens, Royal Bank of Scotland Group Plc said. The currency may trade as low as 290 during 2008, Lucy Bethell, a currency strategist at RBS in London, said in a telephone interview yesterday. The forint declined 0.2 percent to 260.15 per euro as of 12:11 p.m. in Budapest today. Bethell's end-of-year forecast is 280 per euro.

Now, you might ask what on earth this has to do rate setting policy in the Eurozone? Well, not a whole lot of course but it still goes to show some of the risks which loom in the context of EU27 and thus by definition I would argue the Eurozone since the European economies are very interdependent. The second point I want to emphasize is derived from the upcoming G7 meeting where the finance ministers from the group will meet over some well prepared dinners to converse about the global economic edifice after which a 'statement' of some sort will transpire. These things are clearly, if at all, only slightly interesting in themselves but this time around I think that particularly the group dynamics will be interesting to follow. It will thus be interesting to see whether they can come up with some kind of coherent answer to the current global economic situation. My guess is, and this seems to be initially confirmed at this point, that they will have a go at the excess global liquidity issue more so than the issue of faltering economic growth. Now, as ever this will be interesting in the context of the general Japanese situation since they might agree in terms of fiscal policy but what about monetary policy then? Note in this context that Australia raises rates recently and although she is not a member of the G7 clique it goes to show how global differentials continue to widen not least because the central banks are in two minds when it comes to the tradeoff between growth and inflation and this of course will be interesting in a G7 context since they are all there together in the same room talking about currencies etc with their respective central banks shooting off in separate directions. Moving in to more concrete perspective on the Eurozone I had a bit of a chuckle when I read this piece from Reuters (also courtesy of Macro Man) in which German Deputy Finance Minister Thomas Mirow noted how the Eurozone does not exactly like the re-balancing/de-coupling medicine as it is being prescribed at the moment ...

European countries do not want the Euro alone to carry the burden of foreign exchange adjustments, German Deputy Finance Minister Thomas Mirow said on Tuesday. The eurozone is particularly concerned by the rise of its currency versus the dollar because many Asian economies steer their exchange rates up and down in line with the dollar.

I could not have said it more accurately myself and whatever they have on their table in Frankfurt with respect to inflation expectations and monetary supply aggregates I would think that this particular perspective should have a seat to.

In Conclusion

The ECB will hold rates steady when they convene later today to set the main refi rate for the 13 country economic zone. As a result I expect a lot of the same with regard to the discourse emitted from the official statement(s). The most pressing question to answer from a market perspective at this point is when the cut will come assuming that it will come at all in 2008. I think we will see cuts in 2008 but the timing is more difficult. I have previously outlined March as a potential and very early point for a cut and I still maintain that view with the inbuilt put option that the Q4 GDP reading will be decisive as well as of course incoming inflation readings. On the latter I am expecting a slight reversion of inflationary pressures in the months to come which might just be the clue the ECB is waiting for. Of course if I am wrong here it may take much longer for the ECB to come around. Eurointelligence is somewhat at odds with me as regards to the pace with which the ECB is going to cut rates this year. I think they make sense in a lot of ways although not of course in being at odds with me. I agree that the ECB will most likely be steered increasingly by inflation indicators rather than economic indicators. The past 6 months have vindicated this point I think. The big question for me is how bad the economic signals can turn before this bias changes. In connection to the actual timing of the future ECB cuts it is of course damn difficult to call. Eurointelligence does not see cuts in H1 2008. The main message to extract from this is that the ECB is in a bind and now they need to get out of it while keeping a straight face. On a more personal note I want to distance myself from the continuos rant against the Fed and their handling of the US economy; something which is becoming a veritable sport these days.

Finally, we have the ever interesting question of the EUR/USD. As I have promised I really want to come in with a more general view of FX market at some time since I think that, as a market, it is the most direct primer on what are actually the main issues in the global economy. As for concrete calls on the EUR/USD where my general bias for 2008 is a short position I am going to relinquish myself on my forecasting put option that the EUR/USD could go to 1.50. I don’t think this is very probable at this point as previous weeks’ have provided with plenty of testing ground for such a move. Since this has not come to pass even with the most recent lowering by the Fed I think that 1.50 and beyond is out of the question. Whether it will be straight down from here is another question. In time of writing we are looking at a smidgeon above 1.46 and I see the pair moving around 1.46-1.47 in the immediate future. Based on very notional technical analysis I guess that a break of the 1.44 barrier could be a signal to set your play for. I think that fundamental analysis will be ever so important too and especially inflation readings from the Eurozone will be important with respect to whether it goes or not.

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