• US. For many years, the US has been funding its huge trade and current account deficits with massive capital inflows from abroad. These capital inflows are – indirectly – one of the most important sources of funding for the US housing market. The reason for this is the high global investment in the market for securitized mortgages. The recent huge losses suffered by these credit vehicles have heightened investors’ risk aversion. This makes the USD vulnerable to further losses (pages 3-4 and FX Outlook).

  • ECB. At next week’s regular ECB Governing Council meeting, Trichet will adopt a more moderate tone. The strong correction in the sentiment indicators was undoubtedly also a surprise for the ECB, and the threat from the rising EUR continues. This, combined with the higher risk premiums on the money market, has seen the monetary environment tighten considerably. Consequently, the ECB will – despite inflation risks – abandon its tightening bias for the time being (pages 5-6 and chart below).

  • China. The inflation rate in the Middle Kingdom has risen dramatically since the beginning of the year. So far, however, industrialized countries need not be concerned, since to date the spike is attributable solely to higher food prices. China’s political leadership is, however, alarmed: Shortly before the CP Party Congress in October, there is the threat of protests because of the rise in inflation (pages 7-8).

  • Further topics:
    – Weekly Comment: Bumpy road out of the crisis.
    – Data outlook: US labor market to recover in September.
    – Market outlook: EUR to continue to appreciate.


Financial Markets: facing a long and winding road

The Fed’s surprise 50 bp rate cut has successfully bolstered market sentiment, and stemmed the risk that a crisis of confidence would translate into a full-fledged self-fulfilling financial markets crisis. The reaction of equity markets has been particularly strong, but signs of increased risk appetite have also emerged in FX markets and emerging markets. Looking at the interbank and commercial paper market, however, indicates that we are still far from a full normalization. Overall, the evidence from the financial sector suggests that we are in a transitory and delicate phase: the rapid deterioration of the first few weeks of the crisis has been halted, but signs of normalization are tentative and unconvincing as yet.

The real economy is sending similarly mixed signals, although for the time being the overall picture is encouraging and in line with our baseline scenario of a moderate growth slowdown but no severe downturn. In the US, housing data continue to point south, but this is already fully discounted, after even the Fed has stated clearly that it expects housing to be more of a drag on growth than originally anticipated. On the other hand, net exports have emerged as a significant contributor to growth, with two positive twists: First, the contribution is coming from stronger exports rather than just from weaker imports, indicating that a measurable improvement in the external balance can be achieved without a major deceleration in GDP growth; second, the attendant improvement in the external current account could take some pressure off the dollar, alleviating inflation concerns and allowing more room for monetary policy maneuver if needed. The swing factor here is going to be the labor market via its impact on household income. We expect that incoming data will be supportive and will allay the concerns raised by the latest NFP report. If the labor market and income growth hold up, consumption should still prove resilient to the housing downturn. Having said this, risks to our US growth outlook are skewed to the downside, due to both housing and the ongoing dislocation in financial markets. Some additional monetary easing will be needed, and we still expect another 25 bp cut in Q4.

In Europe, we are following with particular attention and trepidation Germany, where the downward trend in confidence indicators is belied by a stubbornly strong labor market. As highlighted in yesterday’s note by Alexander Koch, unemployment has declined by nearly 1 million since the beginning of 2006; coupled with rising real wages, which should provide important support to private consumption. Other indicators in the eurozone have been less comforting, and the most recent rise in the value of the euro both in trade weighted terms and against the USD has of course raised some concern—although we do not believe that the most recent strengthening of the euro justifies serious competitiveness concerns yet. At the same time, however, the ECB will now find itself in a tight spot, as the tightening of credit conditions has increased risks to growth just as inflation is poised to reaccelerate reflecting base effects, and rising food and energy prices are dominating the headlines. As Aurelio Maccario argues in his research note, the ECB might have to drop its tightening bias and settle for a patient wait-and-see period.

We are more concerned about the UK, where the recent Northern Rock fiasco has heightened concerns about the fragility of the banking system. Given the extent to which UK growth relies on the financial system’s performance, and the frothiness of its housing market, the UK appears more vulnerable than either the US or the eurozone to the current turmoil, especially after the latest survey indications that a credit tightening might begin to bite quite soon.

Given also the still buoyant growth of emerging markets, we remain confident that the global economy will be able to weather this crisis paying only a very moderate price. With risks to growth skewed to the downside in the US, Europe and the UK, however, and persistent dislocation in money and credit markets, the road leading out of this crisis will still be long and bumpy.