ECB on Hold - Fed Easing Accelerates

The credit crisis continues to build, and the result is an increasing pressure on the financial markets and central banks to act - something underlined by the collapse of the Carlyle fund in the past week. The Federal Reserve has twice signalled further injections of liquidity to the US money market in the past seven days in an attempt to untie the knot that threatens to spark a downward spiral in the financial markets and also to delay the effects of the Fed rate cuts.

The latest actions by the Fed are a strong signal that it is willing to go very far to alleviate the problems hitting the financial markets. The Fed will not disappoint the market at the monetary policy meeting on Tuesday, and therefore we now expect, like the market, that the Fed will cut by 75bp to 2.25% (See US section).

Steep interest rate cuts in the US stand in stark contrast with what has happened in Euroland, which has so far kept rates on hold. This asymmetry is a significant driving factor behind the pronounced weakening of the US dollar; USD/DKK hit a historic low in the past week of 4.77. While a weaker dollar and a stronger euro are in some ways in the interests of the central banks, as this will contribute to export growth in the US and dampen inflation in Europe, the flip side is rising oil prices. Ever-increasing oil prices are driving inflation higher and growth lower - especially in the US.

Major shifts in FX markets present the central banks with another problem - should they intervene on these markets? We expect that growth in Euroland will weaken enough to prompt the ECB to cut as early as June, which may put a halt to the current carrousel. This will serve to correct some of the asymmetry in monetary policy, and provide some stability to the dollar and hence oil prices.

Euroland: Stagflation Worries Intensify as Both the Euro and Oil Rise

Stagflation is increasingly becoming a problem in Euroland, adding to the dilemma of the ECB. Oil prices and EUR are moving in tandem, and both just keep going higher. EUR/USD hit a new high of 1.565 in the past week, and the trade-weighted EUR has now risen more than 10% in the past six months. According to OECD estimates, a 10% increase in the trade-weighted EUR shaves approximately 0.8 percentage points off GDP growth - hence, the headwind from the euro is quite strong. Oil prices also keep hitting new highs, reaching USD 111 a barrel this week. Even though the stronger EUR limits the damage, it cannot compensate fully (see chart below). This combination adds to the stagflationary pressures, with higher oil prices pushing up inflation - indeed, Friday saw another high in Euroland inflation, at 3.3% in February. At the same time, growth is getting squeezed through the erosion of purchasing power due to the higher oil price and the reduced competitiveness caused by the stronger euro. The ECB stepped up its rhetoric on the euro this week, with ECB president Trichet stating after a BIS (Bank for International Settlements) meeting that "In the present circumstances, we are concerned about excessive exchange rate movements", and adding, "Excessive volatility and disorderly movement…are undesirable for economic growth". As we have stated before, however, if the ECB is mainly worried about inflation, it should actually welcome a stronger euro. Thus, growth worries are clearly on the rise - especially as the data from the US keeps disappointing and the credit crisis is undiminished.

Both PMI and Ifo are due in the coming weeks. The manufacturing part of the surveys has stayed at decent levels, whereas the service sector has taken a more severe hit as a consequence of the weak consumption picture and increasing worries in the financial sector. Industrial data out of Germany has stayed relatively strong, as both orders and exports have only moderated slightly. However, we would not be surprised to see the manufacturing sector weaken in the coming months due to the current strong headwinds.

Key events of the week ahead

• Business surveys will be key over the coming weeks. We look for a decline in both the PMI (coming week) and Ifo (following week).
• Trichet will attend EU parliament on 26 March
• Developments in EUR/USD and oil prices will continue to be important

Switzerland: SNB Keeps Rates at 2.75%

The Swiss central bank (SNB) kept its policy rate unchanged at 2.75% on Thursday at its Q1 monetary policy meeting. At the same time, it revised down its growth forecast and revised up its inflation forecast. The SNB now expects that growth in 2008 will be between 1.5% and 2.0%, and that inflation will average 2.0% this year - indeed, January saw a steep rise in consumer prices, driven primarily by increasing energy prices. Otherwise, there was not much news in the press release from the SNB (see FX Strategi: CHF: Ingen overraskelser i vente på SNB møde [in Danish], 12 March 2008).

While SNB’s Jean-Pierre Roth recently stated on slowing growth and increasing price pressure that it was "not such a comfortable position for a central bank", the head of the ECB, Jean-Claude Trichet, would presumably gladly trade places. True, economic growth in Switzerland is on the wane, but Q4 GDP surprised on the upside, showing an annual increase of 3.6%. Furthermore, while inflation has increased more than expected in the first two months of the year, the SNB still expects that it will be below the inflation target of 2% in Q3. Thus, although the SNB is facing a dilemma of economic slowing on the one hand, and increasing price pressures on the other, this dilemma is less pronounced than in Euroland. This means the SNB can better take the time to wait for additional economic data - time it bought at Thursday’s meeting.

Nevertheless, there is no doubt that further financial turmoil, a US economy flirting with recession and an expected growth slowdown in Euroland will have an impact on the very open Swiss economy. We therefore expect that the SNB will cut rates by 25bp in Q4, when growth will seriously slow, and the ECB will already have begun to ease monetary policy. Hence, we expect that the SNB will ease monetary policy less than the ECB this year, which should further strengthen the Swiss franc, in our view.

The Swiss franc has strengthened by 5% against the Danish krone and 12% against the dollar since New Year, bringing us close to our 3-month forecast for CHF/DKK of 4.78 (CHF/DKK is trading today at 4.74). Continuing financial turmoil, stressed equity markets and expectations of slowing global growth will add further strength to the Swiss franc, in our view, and we maintain our forecast of CHF/DKK at 4.78, 4.81 and 4.84 in 3, 6 and 12 months.

Key events of the week ahead

• January retail sales figures are due on Monday. It will be interesting to see if there are any signs of weakness emerging.
• Tuesday sees the release of industrial production for Q4. The numbers will probably be decent, given the high GDP figure in Q4.

US: Fed Will Not Disappoint - 75bp Rate Cut on the Cards

Financial markets have again deteriorated in recent weeks (see front page). Meanwhile, economic data have increasingly indicated that the US economy is heading for recession; last Friday’s employment numbers and Thursday’s retail sales figures both pointed to a fall in economic activity in February. This was also true of the ISM reports, which showed a downturn in activity in both the service and the manufacturing sectors. In other words, there is a measureable probability that the coming quarters may fulfil the definition of a recession.

The combination of the continuing problems in the financial markets, the sustained downturn in the housing market and the increasingly strong indications that the rest of the economy is stagnating, constitute growing worries for the US central bank. One of the central bank’s worries is that the problems in the financial markets are preventing monetary policy from working optimally. This may mean a greater share of rate cuts than normal being "eaten up" by the problems in the financial system before the cuts reach consumers and companies. This is why the Federal Reserve has taken a number of steps in the past week to help increase liquidity in the money markets (see front page) and so ease the stress in the financial markets, thereby ensuring a more frictionless transmission of the rate cuts.

The Fed has been acting unusually aggressively so far in this crisis, cutting interest rates by 125bp this year alone - and given the weaker data and the continuing problems in the financial markets, there is no sign that the central bank is done with cutting rates yet. Furthermore, we sincerely doubt that the Fed would want to disappoint the markets in the current situation, as this would add fuel to the fire. We therefore now expect a rate cut of 75bp to 2.25% at Tuesday’s Fed meeting (previous forecast was a cut of 50bp). Apart from the Fed meeting, the coming two weeks will be dominated by housing market data and order reports for February.

Key events of the week ahead

• Tuesday: We expect a rate cut of 75bp to 2.25% from the Federal Reserve.
• Thursday: Philadelphia Fed index expected to recover a little to -19.
• Housing market figures on Monday and Tuesday before Easter, and Monday and Tuesday after Easter.
• Industry orders Wednesday after Easter.

Asia: Opposition Blocks Appointment of New BoJ Governor

During the week, the opposition in Japan’s upper house formally blocked the appointment of Toshiro Muto as the new governor of the Bank of Japan (BoJ). Muto is currently deputy governor of the bank, and had been the clear favourite to take over when the current governor, Toshihiko Fukui, steps down on 19 March. The opposition also blocked the appointment of one of the two deputy governors, Takatoshi Ito, although the appointment of the other, Masaki Shirakawa, was passed.

In reality, the opposition’s motives for blocking the appointment of the new governor have little to do with either Muto or the BoJ. Above all, the opposition wants an election soon, and so it is trying to make life as difficult as possible for the current Fukuda government. The opposition’s formal reason for blocking the appointment of Muto is that it is against rewarding senior ministry officials with high-profile positions such as this. Muto comes from a career at the finance ministry. It is looking increasingly likely that an alternative candidate will have to be found. The coming week will bring a focus on finding a temporary solution ahead of 19 March. There are currently two possibilities: one is to make some quick changes to the legislation so that Fukui can continue as governor until a permanent solution is found; the other is to make new deputy governor Shirakawa acting (and maybe even permanent) governor of the BoJ.

So what are the implications of this sudden leadership vacuum at the BoJ? A lot of attention is currently being given to the possibility of intervention in the currency market to stem the decline of the USD, but this is not really an issue, as responsibility for deciding whether or not to intervene rests with the finance ministry. On the monetary policy front, the BoJ is probably not completely paralysed, but it will be harder to make any major changes to monetary policy when the bulk of the bank’s management is not yet in place. Given the current turmoil in financial markets, the timing of the political conflict over the appointment of a new governor is unfortunate. The unstable political situation means that there will probably be elections to the lower house in the autumn.

Key events of the week ahead

• Japanese foreign trade figures are due out on Wednesday 26 March. The main focus will be on exports.
• Japanese unemployment and consumer price data will follow on Friday 28 March. We expect unchanged unemployment of 3.8% and a slight rise in inflation to 0.9% y/y.
• In China, the National People’s Congress draws to a close on Tuesday 18 March. The new government is expected to be appointed in the coming week.

Fixed Income: Financial Crisis Rages On

The financial crisis has escalated again, and is completely dominating the agenda in fixed income markets at present. Credit spreads have risen sharply, and the problems in the money markets have picked up again. The spread between swap and Treasury rates has increased substantially, with swap rates falling far less than Treasury rates recently. The 2Y swap rate has, however, risen as a result of revised monetary policy expectations in Euroland in light of the ECB’s relatively hawkish inflation rhetoric.

At the same time, a number of markets have been hit far harder this time around, including US mortgage bonds and US municipal bonds. Meanwhile, the yield spread between Germany and the rest of Europe -including Denmark - has widened sharply (see chart below). It is difficult to explain movements in intra-European spreads with fundamental arguments. The widening is due primarily to increased risk aversion, combined with self-reinforcing mechanisms that have created a situation of very poor liquidity in the Euroland bond markets, and this has spread to Denmark.

It is very difficult to keep track of all the different stories that together make up the current financial crisis. In an attempt to provide a relatively straightforward overview, we have sent out a new publication, Financial Crisis Update, which will be updated regularly for as long as the financial crisis continues.

The Federal Reserve meeting on 18 March is the big event over the Easter period. We expect a 75bp rate cut, which is in line with market expectations. Due to Easter, this edition of Weekly Focus covers the next two weeks. This period will bring a string of data on the US housing market which will undoubtedly confirm its sorry state: NAHB index, housing starts, building permits, sales of existing homes and house prices are all on the agenda. Durable goods orders and various regional business confidence indices are also due.

In Euroland, attention will focus on the PMI and Ifo confidence indicators. We expect the PMIs to continue to fall. The Ifo index has held up surprisingly well so far, but we feel it is only a matter of time before it too starts to slip. There is the risk of a negative surprise from the Ifo index. European data will probably confirm our expectation that an ECB rate cut is edging closer, but yield movements will be dictated by how things pan out in the financial crisis.

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After a few months of acceleration, inflation moderated this month surprisingly led by a decline in energy prices! This gave the dollar some support as reactions in the market showed the greenback increasing but the forces of confidence were too strong…

The Labor Department released in their report the CPI reading for the month of February coming in flat from the previous reading of 0.4%. The annual reading also showed deceleration to 4.0% from 4.3%.

As for the core prices - excluding volatile food and energy costs- were also flat in February opposing the expected and previous readings of 0.2% and 0.3% respectively marking the lowest rate since November 2006. The year on year reading slipped also to 2.3% from 2.5%.

Energy prices fell 0.5% in February making it the biggest drop since last August but this might just be on the short-term since nowadays we’re seeing new record highs in the oil market as it breached the $111.00 per barrel level. Gasoline prices dropped in the beginning of the month by 2% according to a survey conducted by economists but later jumped heavily. Electricity prices fell 0.3%.

Prices for medical care increased a slim 0.1% while clothing prices fell 0.3%, the biggest drop since last August. Transportation prices dropped 0.7% led by airline fares and new vehicle prices falling. Food prices rose 0.4% on the month. Housing prices, which accounts for 40% of the CPI index, rose 0.2% for the second consecutive month while rent increased by 0.2% as well.

CPI rates are still above the end of the Fed’s comfort zone of around 1.5%-2.0% but Fed officials now expect inflation to moderate in coming months after the release of the latest CPI data. This still doesn’t mean that risks have vanished since oil prices are still on the rise.

With these numbers out odds for a 75 basis point cut in the next Fed meeting on Tuesday is expected but still giving the Feds a wider range to cut rates. However, with the ripple effects from both the housing and credit crunch still does not suggest that the next rate cut is the end.

In another report, The University of Michigan released its Confidence preliminary reading for the month of March coming in at 70.5 slightly higher than the expected reading of 70.4 and lower than the prior reading of 70.8. This is the lowest reading in 16 years. The current conditions index improved to 84.6 from 83.8.

Gold prices spiked to breach the $1000 per ounce psychological level and the dollar started to loose grounds against the majors. With the rate cut to come, there is no floor to support the greenback! I guess the lows are still to be seen so dear reader place your bets on how far down the dollar will go and how much of a cut we will be witnessing…

Crown Forex

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Downward pressures persists for the US dollar as fresh economic data added to recessionary concerns and pushed the crumbling dollar to new record lows. The US dollar touched new record lows against the Swiss franc and the euro, while the yen - pulled lower by risk aversion - tested the intervention-friendly 100 level for the first time since 1995. Elsewhere, the commodity currencies surged against the US dollar, with the New Zealand and Australian dollar picking up the biggest gains with help from their respective economic calendars. The Canadian dollar found its leverage through $110 oil and gold touching a record high of $1000. And despite its tepid interest through the SSI positioning, GBPUSD rallied to 2.04 .

The dollar continued to suffer the brunt of the pain delivered to the financial markets by news that Carlyle Capital would have to surrender all of its assets to its lenders after failing to meet a $400 million margin call. Not only does this stoke fears that other hedge funds and more mainstream investment houses are at risk of the same fate, but it also means another $16.6 billion in debt could be dumped on an already saturated market very soon. Under normal circumstances, such news would actually favor the dollar against high yielders; but this wasn’t the case this time around, as fears of a recession and President Bush’s admission that the economy is weak has refreshed dollar traders concerns. The economic docket further weighed on the greenback. The frequently market moving retail sales report added another reason for economists to forecast and policy officials to fear a coming recession. Sales dropped 0.6 percent, with an expected decline in discretionary spending meeting an unexpected drop in gas and food sales. Upstream inflation is still threatening to give the Fed a hard time after the import price index merely ticked lower to a still oppressive 13.6 percent annual rate. Even unemployment benefits filings were weighing the dollar down as continuing claims rose to a two year high.

The stock markets turned around after taking a dive during the morning session as Standard and Poor’s stated that the write-downs from the subprime mortgage crisis may soon come to an end with total losses estimated at $285B. As a result, the DJIA retraced the 200 point plunge in the morning - gaining 35.42 points by the end to bring the index to 12,145.66. Out of the big 30, Boeing and McDonalds picked up the biggest gains, while AIG and IBM topped the losers. Among the broader indices, the S&P500 picked up 6.71 points with LDK Solar shares picking up the most, while Virgin Mobile and Thornburg Mortgage shares lead the losers.

Investors left the safe haven of US Treasuries after Standard and Poor’s lifted spirits by forecasting an end is near for subprime writedowns. As a result, the benchmark 10-Year yield jumped to 3.52 percent from 3.46 percent while the 2-Year yield increased to 1.61 percent from 1.60 percent.

Looking ahead, tomorrow could potentially be an eventful day as traders take in the consumer price index and University of Michigan’s consumer sentiment survey for readings on both inflation and growth - the defining components of the Fed’s next rate decision.

DailyFX

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Asian Morning Update

European releases overnight:

Rather scattered news from Europe overnight. The ECB published its monthly bulletin with the headline statement: ‘The firm anchoring of medium- to long-term inflation expectations is of the highest priority… the Governing Council believes that the current monetary policy stance will contribute to achieving this objective.’

It was nothing more than has been repeated many times by Trichet who reiterated by commenting: ‘If we were no longer credible in ensuring price stability, households would loose confidence, and the financial markets themselves would be more turbulent.’

With gold hitting record highs at $1,000 per ounce and oil hitting $111 pb at one time the world is going to face a long period of above average inflation. It beckons likening the situation to the U.K. in the 1970’s which brought union unrest, high wages demands and strikes during the oil crisis that took inflation into double digits.

With European banks still expected to announce much greater writedowns due to the subprime debacle credit spreads are going to remain higher and credit screening tighter.

The prospect for a return to growth levels of the past 5 years is very slim.

States releases overnight:

The U.S. almost looked like returning good numbers but fell at the last fence. Higher than anticipated business inventories should be seen in the light of total sales at +1.5% over the month which kept the stock-to-sales ratio (1.25:1) slightly below December’s level. A year ago the ratio was 1.3:1 and suggests that U.S. businesses are fighting the slowdown with a combination of improved productivity and cost controls.

For all that mildly encouraging news retail sales slumped in February which really reflects what the MasterCard’s SpendingPulse reported with February spending taking a -1.1% dive.

And so the Dollar was sold again.

It has almost become a daily habit now, the easy route and just about self-fulfilling. That is why the central banks are becoming more concerned.

A 10% drop in the Dollar versus the Euro in three months is by any definition excessive and this makes the 15% drop against the Yen even worse.

Without a doubt the Dollar is oversold but habits die hard with every additional bad release causing a 1% drop it seems. The Dollar is overdue for a correction but the problem is now one of fear.

Every attempt the Dollar has made at generating a meaningful correction over the past 3 months has been muted and rapidly turned into a new rout. Market players are creatures who like a simple life. Long Dollar positions have made their life difficult. Short Dollar positions have been comfortably profitable.

Until there is cause to doubt the downside they will shun the upside.

With increasing rhetoric from central bankers on exchange rates it could be argued that the market is being prepped for concerted intervention. However, until – or unless – it actually happens long Dollar positions are plainly out of favor.

More later once the daily analysis has been done…

There are no economic releases due from Asia due today:

Ian Copsey
Global Forex Trading
http://www.gftforex.com

DISCLAIMER: This forum and the information provided here should not be relied on as a substitute for extensive independent research before making your investment decisions. Global Forex Trading is merely providing this column for your general information. The views of the author are not necessarily those of Global Forex Trading, its owners, officers, agents or employees. In addition, any projections or views of the market provided by the author may not prove to be accurate. Global Forex Trading and Cornelius Luca will not be responsible for any losses incurred on investments made by readers and clients as a result of any information contained in this column. Global Forex Trading and Cornelius Luca do not render investment, legal, accounting, tax, or other professional advice. If investment, legal, tax, or other expert assistance is required, the services of a competent professional should be sought.

After having been down over 200 points, the Dow Jones Industrial Average staged a remarkable recovery.

In reaction to the move, the Japanese Yen crosses have also rebounded, but other than AUD/JPY, NZD/JPY and CAD/JPY, all of the Yen crosses remain in negative territory. Although it may be tempting to buy into the carry trade recovery, we continue to warn against doing so. The financial markets are very volatile and traders are still risk averse. This should keep a lid on any meaningful recovery.