• Hope. The severe US recession will most probably end in the second half of the year. Many market observers are betting on a rapid, strong and sustained upswing thereafter. They are drawing support from the renewed strong gains this week in sentiment and leading indicators.

  • Exaggerated. It should not, however, be overlooked that most of these indicators had still posted record lows at the turn of the year. Even after the recent strong gains, current levels imply little more than a moderate recovery by the US economy. To signal a truly strong upswing, we calculate purchasing manager indices or consumer confidence would have to post much stronger gains (pages 3-5).

  • Unattractive. But merely the prospect of an end to the recession has sufficed to trigger a sustained decline in risk aversion in markets. Equities around the globe posted strong gains, and the "safe-haven status" of the USD and US Treasuries lost much of their appeal recently.

  • Dilemma. Rising bond yields do, however, harbor the danger of a tentative recovery – first and foremost in the US housing market – being nipped in the bud. And any further expansion of the purchase of Treasuries could prove counter-productive via a weaker USD and rising inflation expectations. The Fed is facing its next dilemma (pages 6-7).

  • Further topics:

    – Weekly Comment: Still plenty of work for the ECB (page 2).

    – United Kingdom: Labor market under stress (page 8).

    – Data outlook: Purchasing managers' confidence will continue to rise; US payroll figure to be deeply in red next week (page 10).

    – Market outlook: Government bonds to remain under pressure; EUR performance dependent on ECB (page 17).


ECB: Still plenty of work to do

The ECB takes center stage again next week. After the momentous announcement at the May meeting that the Governing Council had agreed in principle to launch direct purchases of covered bonds for an amount of EUR 60 bn, the markets will be eagerly awaiting clarification on some key details of the purchase program. First and foremost will be a clarification on whether or not the ECB intends to sterilize the purchases. At the May meeting, ECB President Trichet did not offer a definitive answer, suggesting that the Governing Council had not yet reached an agreement. But this is of course an extremely important feature of any direct asset purchase program, and will need to be clarified next week. At the last press conference, Mr. Trichet noted that the purpose of the measure was to improve conditions in a specific segment of asset markets, rather than achieve a loosening of overall monetary conditions. This would seem to signal that purchases would be sterilized. We believe that what is needed at this stage is not just to help revive the covered bonds market, but to provide more liquidity to the economy, and that therefore the purchases should not be sterilized. We are also concerned that sterilization would trigger tension on the assets that the ECB would choose to sell in order to sterilize the covered bonds purchases.

In our view, the ECB should also make clear that the door is left open to a possible extension of the quantity and the kind of assets eligible for direct purchases. The announced EUR 60 bn is a good first step, but unlikely to be sufficient if the slump in activity persists. In addition, the risk of a credit crunch still looms. Granted, our recent analytical work (see also Research Note: Eurozone credit contraction, Friday Notes of May 22) shows that it is still nearly impossible to prove that a restriction in the supply of credit has played a role independently of the contraction in credit demand triggered by the recession; and the most recent bank lending survey shows that the tightening in credit standards is now abating. However, with eurozone banks now slated to feel the pressure from increasing non-performing loans, the risk that as economic activity stabilizes any recovery in credit demand might be stifled by a credit supply restriction should not be underestimated.

Finally, a further concern to the Eurozone’s growth outlook comes from developments in FX markets, where the recent upsurge in risk appetite has undermined the USD and boosted the common currency. As hopes for a Eurozone recovery still rely to an important extent in a recovery in exports, an excessive further appreciation of the EUR constitutes a non-negligible risk.

At the same time, the ECB is demonstrating its steady-hand approach by not getting overly excited about the "green shoots" of recovery, and we hope that this prudent attitude will be confirmed at next week’s meeting. Our own analysis confirms that the "green shoots" are widespread in the global economy, an important sign of resilience. Within the eurozone, we have seen several signs of stabilization, for example, a pick-up in Italian consumer confidence as one of the latest signals. We are quite confident that the turning point has been reached, and that the worst is indeed behind us. However, as Mr. Trichet has pointed out, what we are seeing so far is stabilization after a collapse of economic activity to extremely low levels. Moreover, downside risks still predominate. We are therefore still at a stage where the policy support should be maintained, to maximize the chances that the recovery will become entrenched. In this respect, the ECB’s sober assessment of the "green shoots" so far is highly encouraging.

In a similar vein, we hope that the ECB will also reiterate its commitment and readiness to tighten policy in a timely manner once the recovery takes hold. The debate on whether or not more stimulus is needed is a legitimate one, and the debate on the exit strategy is perhaps even more important. Signaling that the ECB is determined to tighten policy as soon as appropriate, and confident that it will identify the right timing, will play a crucial role in maintaining confidence and keeping inflation expectations well anchored.