Euro Zone, Swiss Prices Set to Fall Again, Stoking Deflation Fears (Euro Open)

Consumer and producer price indexes out of the Switzerland and the Euro Zone, respectively, are both set to push deeper into negative territory, stoking fears that the onset of deflation will delay economic recovery across the Continent.

[U][B]Key Overnight Developments[/B][/U]

[B]• New Zealand’s Wages See Smallest Gain in 9 Years in Q2
• RBA Leaves Rates at 3%, Cuts Language Hinting Future Easing
• Australian Retail Sales Unexpectedly Fell 1.4% in June[/B]

[U][B]Critical Levels[/B][/U]

The [B]Euro [/B]slipped marginally lower in overnight trading, giving back 0.3% against the US Dollar after surging higher in the New York session. The [B]British Pound[/B] oscillated in a wide 80-pip range below 1.70.

[U][B]Asia Session Highlights[/B][/U]

New Zealand’s [B]Private Wages[/B] rose 0.3% in the second quarter, issuing the smallest increase in 9 years and underperforming economists’ expectations of a 0.5% result. Rising unemployment accounts for the slump in compensation, reflecting the same kind of aggressive cost-cutting that has been seen across firms in industrial economies and that has produced upside earnings surprises over recent weeks despite small to non-existent revenues. The release foreshadow employment numbers set to cross the wires later in the week, with forecasts suggesting the jobless rate ticked higher to 5.7% in the three months through June, the highest reading since the fourth quarter of 2000. Slowing wage growth also points to lower overall inflation, creating a relatively safe environment for the central bank to lower interest rates. As we noted in this week’s New Zealand Dollar weekly forecast, a rate cut is the next logical step to check the recent gains in the domestic currency that have weighed on exports and “derailed” the economy, according to Prime Minister John Key. Indeed, the [B]ANZ Commodity Price[/B] Index showed that the price of New Zealand’s top export goods on global markets grew 1% in July. In terms of the domestic currency, however, the price index grew just 0.1% after the New Zealand Dollar surged 2.5% in the same period, making goods produced in the smaller antipodean country comparatively more expensive to overseas versus domestic buyers and driving away foreign demand. Exports contribute up to 30% to overall economic growth, making a slump in outbound shipments an acute threat to a sustainable recovery from the current downturn.

The [B]Reserve Bank of Australia[/B] kept interest rates unchanged at 3% for the fourth consecutive month, as expected. RBA Governor Glenn Stevens sounded decisively optimistic, conspicuously removing comments leaving the door open for future rate cuts that have been included in the bank’s official policy statements over the past two months. Rather, Stevens said that current monetary policy is “appropriate”, noting that “the global economy is stabilizing” while the “downside risks to the global outlook have diminished”. Stevens talked up Australian performance in particular, saying “both consumer spending and exports [are] notable for their resilience” and going so far as to argue that “risk of a severe contraction in the Australian economy has abated.” From here, the RBA expects a period of slow growth as the economy regains a firmer footing, with expansion to pick up pace into 2010. On inflation, the bank expects prices to continue to moderate over the coming year, with the stronger Australian Dollar helping to drive prices lower. Stevens did qualify his exuberance a bit when it came to speaking about credit markets, saying these continue to “present a challenge” and warnings that continued progress in restoring bank balance sheets is essential for the recovery to be “durable”.

Separately, Australian [B]Retail Sales[/B] unexpectedly fell -1.4% in June, the first decline in four months, disappointing expectations of a 0.5% expansion. While it is too early to be said definitively, the release may suggest that the effects of the government’s A$12 billion in cash handouts to households that has propped up consumer sentiment in recent months may be starting to abate.

[U][B]Euro Session: What to Expect[/B][/U]

Switzerland’s [B]Consumer Price Index[/B] is expected to fall -1.1% in the year to July, yielding the lowest reading in at least 33 years and the fifth consecutive month that the annual pace of inflation prints in negative territory. Strictly speaking, deflation implies an appreciation of the Franc, with falling prices boosting the currency’s purchasing power. Perversely, this means that the Swiss unit could actually see near-term buying interest following lower CPI figures. That said, the longer-term effect is difficult to gauge considering the Swiss National Bank has explicitly committed to “take firm action to prevent an appreciation of the Swiss franc” to keep expectations of future prices from becoming entrenched in negative territory, an outcome that would prolong the current downturn as consumers and businesses delay spending and investment as they wait for the best possible bargain. On balance, it is much easier for a central bank to drive the domestic currency lower than to support its value against speculative assault because it can simply print more of it, suggesting any upside is likely to be short-lived.

Turning to the Euro Zone, the [B]Producer Price Index[/B] is set to contract by a record -6.6% in the year to June. The metric foreshadows continued downward pressure on consumer prices, the headline inflation gauge, as lower wholesale costs are reflected in the final price tag. As with Switzerland, the currency bloc now faces a credible deflationary threat that threatens to keep derail recovery from the current downturn. As we have mentioned on numerous occasions, the European Central Bank has struggled to formulate an effective policy response to such a possibility thus far. Jean-Claude Trichet and company have focused on banks as the vehicle through which to make money cheaper and put a floor under falling prices, promising unlimited lending to the region’s financial institutions including an unprecedented 442 billion euro in 12-month bank loans and a 60 billion bond-buying scheme. To the central bank’s credit, borrowing costs have indeed moved lower: although the ECB publicly maintains target interest rates at 1%, it has allowed the average cost of overnight lending (referred to as EONIA) to drift far below that. Indeed, borrowing in Euros has been consistently cheaper than doing so in British Pounds since late June, even though the Bank of England’s stated interest rates are substantially lower at 0.5%. However, the lower cost of credit between banks has not translated into lending, and so has offered little stimulus to the overall economy. Indeed, loans to Euro Zone businesses and households grew just 1.5% in June, the lowest since records began in 1991. Banks may be choosing to hang on to cash as a buffer against $1.1 trillion in as yet unrealized losses linked to the subprime mess, according to the IMF, as well as the fallout from looming defaults and/or devaluations among the EU’s newly-minted central European members. In any case, although the Euro has gained on the back of surging risk appetite, the door is open for traders to punish the single currency as fundamentals return to the forefront. Indeed, the ECB’s inability to ensure that looser monetary conditions translate beyond the interbank market make deflation all but certain, amounting to lower interest rates for comparatively longer than other central banks.

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