A slowing US economy always affects the rest of the world (RoW) with a delay. For Euroland, historically, the delay has been 1-2 quarters. Possibly due to the fog of uncertainty, investors may be attaching more weight to current data and not projecting forward the impending slowdown in Euroland. While the list of concerns on investors’ minds has not changed in the last two months, the macro data from around the world last week were, on balance, on the strong side, suggesting that the world might de-couple from the US, at least temporarily. If the world keeps growing despite a faltering US, the dollar should not enjoy a strong safe-haven bid. Risk capital already began to return to some EM markets last week and global equities seem to be forming a tentative bottom. We are still early in the recession process, but the latest twist of data and the subtle shift in investors’ mood are remarkable.
[I][I]Stephen Roach, Head Economist, Morgan Stanley[/I][/I]
[B]Weekly Bank Research Center 03-03-08[/B]
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[B][B][B][B][B] Is the ‘Dollar Smile’ Idea Still Valid? [/B][/B][/B][/B][/B]
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[I] Stephen Roach, Head Economist, Morgan Stanley [/I]
If we had been told, at the beginning of the year, that the US would be on the precipice of falling into a recession, that the Fed would cut rates more aggressively than at any point in the post-WWII period, but that Euroland and Asia would somehow remain resilient, i.e., de-coupled from the US, most of us would have guessed that EUR/USD would be much higher than 1.50. My point is that the ‘Dollar Smile’ has worked in the past few weeks, as fear-motivated capital flows balanced out the negative interest rate carry for the dollar. We are not abandoning the ‘Dollar Smile’ framework, but recognise that the different policy and economic fundamentals than we had assumed have made the ‘Dollar Smile’ rather ‘fixed’, and conditions will need to change to make it smile again. Specifically, while we still believe that fear will return as the US and the world’s economic fundamentals deteriorate, i.e., the ‘Dollar Smile’ should work again some time in the future, the lag between a slowing US and a slowing Euroland will likely be long enough that EUR/USD could stay higher than we had thought.
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[B] A Stagflationary Forecast Revision from ECB [/B]
[/B] [/B] [/B] <em> Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank
The key event in the coming week will be the ECB meeting on Thursday. Rates are expected to remain on hold at 4.0%, but the press conference where ECB will present the new staff projections should draw a lot of attention. We expect ECB to present a revision with a flavour of stagflation, as it is likely to revise up the inflation projection while at the same time revising down the growth projection. On inflation the news since the last projection has pointed to further upside risks. Firstly, oil prices have climbed higher again rather than fallen back as was previously expected. Secondly, food prices have risen more strongly in recent months driven by goods like milk, eggs, cereal and bread. We still have not seen noticeable increases in meat prices, which may show up in coming quarters. Renewed price increases in commodities like wheat and corn are also putting more upward pressure on food prices. These factors imply that inflation could be sticking around 3% for the first half of 2008 before starting to come down gradually. On the back of this news we expect ECB to raise the central point in its inflation projection for 2008 to 2.7% (previous 2.5%). For 2009 we think ECB may raise the projection slightly to 1.9% from 1.8%. This means it will be very close to its upper limit of 2%.
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[B] Mixed Signals on US Inflation [/B]
[/B] [/B] [/B] [I] E. Silvia, Ph.D. Chief Economist, Wachovia[/I]
Trying to get a sense of inflation expectations is a tricky business. But it is a worthwhile exercise because expectations have a tendency to serve as a self-fulfilling prophesy. Fed Chairman Ben Bernanke said in a speech last summer that “undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price stability.” The problem, at least at the moment, is there are conflicting signals about these expectations. The most easily identifiable measure of consumers’ thoughts on inflation comes from the University of Michigan Survey. Over the last few months the inflation expectation for one year ahead has trended up, while the expectation for five years out has remained flat. One measure of the market’s inflation outlook is the ten year TIPS spread – the difference between the yield of a Treasury bond with inflation provisions, and a Treasury bond without. While trending modestly higher in recent weeks, the TIPS spread is roughly where it was at the end of last year, and below where it was during much of the fourth quarter. Yet another measure of price expectations is gold and other hard commodities. Over the last several weeks just about every precious metal has climbed in price, suggesting potential concerns about higher inflation.
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[B][B][B][B][B] Chairman Bernanke Focuses on Growth with Hopes of Slowing Inflation [/B][/B][/B][/B][/B]
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[I] Steve Chan, Economist, TD Bank Financial Group [/I]
Chairman Bernanke’s language heard in his testimonies to U.S. House and Senate committees was mostly focused on economic weakness. Inflationary concerns were duly noted but not brought to the forefront. The Fed is still hoping that slower economic activity will eventually translate into weaker inflation. It had better hope this happens soon. Declining home prices have so far failed to translate into weaker inflation. The U.S. dollar declined further this week, partly in anticipation of lower rates. This puts further pressure on import prices and overall inflation. In particular, oil prices keep hitting new record highs, above $US102/bbl on Thursday. Very little slack has opened in the labour market. All of which puts the Fed in a bind. Its preferred inflation gauge, the core PCE index, showed little sign of easing in January at 2.2% year-over-year, unchanged from December. A few more months at these or higher levels and further increases in market expectations for inflation could turn the tables and have the Fed refocus on its price stability mandate. No one ever said that maintaining price stability and the expectation thereof was going to be easy, as the current episode is highlighting. We think the Fed’s quandary will limit the extent of further easing to 50 basis points in the near-term.
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[B][B][B][B][B] Negative Real Interest Rates to Persist in the US [/B][/B][/B][/B][/B]
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[I] Trevor Williams, Chief Economist at Lloyds TSB Financial Markets [/I]
Fed Chairman Bernanke gave a green light to expectations of lower interest rates to support economic growth. Although Bernanke acknowledged that inflation risks had risen, the predominant concern remained the downside risks to growth. The next scheduled meeting is on March 18, when rates are forecast to fall by half a point to 2.5%. Beyond the short term, however, Bernanke noted that the current negative real interest rate cannot be maintained indefinitely, suggesting that the Fed will quickly reverse recent policy easing, once the impact of the credit crisis subsides and downside growth risks fade. The current US data flow was broadly negative, however. Consumer confidence fell to 75.0 from 87.3, the lowest since March 2003, while initial jobless claims rose to 373,000, which may signal a soft employment report next Friday. Housing market indicators remained weak, with the Case/Shiller house price index showing a 8.9%y/ y fall in Q4 and new home sales in January declining 2.8% to 588,000. Inflation indicators, however, increased, with producer price inflation rising to 7.4%y/y in January and the PCE deflator rising to 3.7% (core PCE deflator was steady at 2.2%). Reflecting increased inflation concerns, US 2-year breakeven inflation has risen to 2.25% and gold has increased to a high of $976. Ten-year nominal bond yields fell from a high of 3.93% to a low of 3.55%, ending the week at 3.58%. The 2s/10s curve continued to steepen, rising to 187bps, remaining near the highest level since 2004.
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[B][B][B][B][B] Other Pre-screened Independent Contributors[/B][/B][/B][/B][/B]
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[I] J-Chart [/I]
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