Entries from February 1, 2008 - February 29, 2008
ECB-ometer moving towards rate cut territory
Simon Ward
Post a Comment
I have updated my ECB-ometer ahead of next week's policy meeting. The model suggests an "average interest rate recommendation" among the 21 Governing Council members of -10 bp, insufficient to trigger a forecast of a rate cut (threshold -12.5 bp) but consistent with a clear easing bias. This is the most dovish reading for 30 months - see chart. (More explanation of the model can be found here.)
The further shift over the last month reflects a combination of slower fourth-quarter GDP growth, a rise in the euro and a decline in short-term government bond yields, partly reflecting further credit market deterioration. With business and consumer confidence stable but lacklustre, these changes would have triggered a forecast rate cut but for continuing high inflation and money supply readings.
The model is now diverging significantly from the neutral policy stance articulated by ECB President Trichet at the last press conference, not to mention recent more hawkish comments from Bundesbank President Weber. The Bundesbank intervention is probably aimed at heading off a shift to more dovish language in next week's statement. It may succeed this month but pressure continues to build for a rate cut in the second quarter, with May currently looking the most likely month.
Scrap the G7 - it's not working
Are the Fed and the ECB on different planets?
Yesterday, Fed Chairman Bernanke signalled a further cut in official rates on 18 March despite recent unfavourable inflation news and the 225 bp of policy stimulus already in the pipeline, not to mention a substantial expansionary fiscal package.
Meanwhile, Bundesbank President Weber poured water on hopes of a cut in ECB rates even though credit conditions are as bad in Europe as in the US and growth has moved below trend, with a risk of serious weakness in several Eurozone economies.
This policy divergence looks unsustainable. With the real Fed funds rate approaching historical post-recessionary levels, the US central bank may shift to a neutral bias after the expected March cut. Despite Weber's comments, the ECB is unlikely to reverse its recent shift to a more neutral stance at next week's meeting. Events continue to play out similarly to 2001 (see here for more), suggesting a rate cut is still plausible by mid-year.
Unsurprisingly, the dollar was a major casualty of yesterday's remarks, finally breaking below its November trough in trade-weighted terms. A sharp increase in currency volatility would be unwelcome against a background of continuing turbulence in other financial markets. Greater policy co-ordination would serve both the Fed's and the ECB's interests.
More glimmers of hope for US housing
US home sales – adding together new homes and pending sales of existing units – plunged by 26% between December 2006 and August 2007. In posts in October and December I suggested activity was bottoming, in which case stock prices of US homebuilders should start to recover.
Combined sales slipped a further 2% between August and December and probably weakened again in January (new sales were down another 3%). Leading indicators have improved, however. Reflecting lower prices and mortgage rates, and possibly also recent government action aimed at boosting the supply of "jumbo" loans, the home-buying conditions index of the University of Michigan consumer survey strengthened in early February – see first chart. According to the February NAHB homebuilders survey, "traffic of prospective buyers" has risen to its best level for seven months.
Inventories of unsold new homes remain very high by historical standards but have fallen by 16% from a peak in July 2006. The decline should accelerate since new construction has fallen well below the level needed to cover the current pace of sales, which may now recover.
The S&P homebuilding group index has rallied 53% from a "double bottom" low traced out between November and January. The recovery is small relative to the prior fall but the technical position looks promising, with the index having broken and then found support on two significant downtrend lines – see second chart. A move back above the early February high would signal the likelihood of further gains.
Fed index suggesting no recession through January
The Chicago Fed national activity index is a weighted average of 85 monthly economic indicators and has an excellent coincident relationship with GDP. As the chart shows, recessions are signalled by the index falling below -1. Historically, this has usually occurred at the onset of economic contractions.
Preliminary January figures released today show the index above the trigger level, at -0.58. This is up from -0.69 in December (revised from a preliminary -0.91).
Shocking Fed survey - but is it bearish for stocks?
Monday’s post expressed concern about a recent sharp deterioration in business and consumer surveys. The February Philadelphia Fed survey of regional manufacturers, released yesterday, was another shocker, with the expected new orders index plunging into negative territory – a rare occurrence. As the chart below shows, this suggests further weakness in the national ISM survey to be released on 3rd March.
This morning’s “flash” Eurozone purchasing managers’ surveys were more reassuring, however, with the manufacturing new orders index only slightly lower than in January and the services new business index recording a surprise recovery. It could be that the Eurozone surveys are proving slower to pick up emerging economic weakness but it is also possible that the slide in US confidence has been exaggerated by the Fed’s panic rate cuts, which suggested the central bank believed a recession had started.
The Philadelphia Fed survey does not resolve the recession issue. The expected new orders index has fallen below zero on five previous occasions since the survey’s inception in the late 1960s. In four of the five cases a recession followed but in two of these it began more than a year later. In one case – 1995 – the economy skirted recession.
Nor is the survey’s weakness necessarily a signal of further equity price falls ahead. In the five prior instances of expected new orders turning negative, the average change in the S&P 500 index over the subsequent six calendar months was +8.8%. The change was positive in four of the five cases, the exception being 1973 – but this was in the context of the orders index continuing to plunge to a record low of -43.
Commodities boosted by liquidity / Fed
What are the implications of the continuing surge in commodity prices?
The first implication is that there is no shortage of global liquidity available to chase a “hot” investment theme. This is consistent with the current large gap between G7 real broad money supply growth and industrial output expansion – see chart. As I have argued previously, this gap is helping to cushion the effect of credit tightening on economies and markets.
Secondly, the commodity surge supports my view that Fed easing has been counterproductive, serving to boost inflationary risks rather than stimulate the real economy. The Fed should have waited for inflation expectations and commodity prices to soften before cutting rates aggressively.
Thirdly, the squeeze on G7 real incomes implied by rising commodity costs will sustain current economic weakness. However, I still think a recession / hard landing can be avoided and momentum will improve later in 2008 as looser monetary conditions offset credit tightening. More on that soon.
