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KBC Flash

FOMC keeps rates unchanged; No sign of imminent start of tightening cycle

Thu, Jun 26 2008, 07:54 GMT
by KBC Market Research Desk

KBC Bank

• • FOMC keeps rates unchanged for the first time in seven meetings….

• • .....puts more emphasise on risks to inflation and inflation expectations....

• • .....but keeps downside growth risks ....

• • .... Dallas Fed governor Fisher dissents in favour of an increase of the Fed Funds target rate

• • ….markets reacts subdued, but near term rate hike is now very unlikely.

The FOMC decided to keep its rates unchanged yesterday. It was the first meeting in seven or the first time in 10 months, it didn’t cut its interest rates. The statement clearly shows that the Fed remains in an ackward position as it is confronted at the same time by lacklustre growth and recession risk, increased inflation risk and a financial sector that is severely weakened by the credit crisis, all three factors were mentioned in the statement.

In this context, the Fed stopped short from adopting a tightening bias, as it cited both downside risks to growth and increased upside risks to inflation and inflation expectations without calling one of them as a predominant risk. We conclude that the Fed has a neutral bias, but admit that at the margin they seem to take the inflation risk as being slightly more important than the growth risk, also as Dallas Fed governor Fisher dissented in favour of an immediate tightening. However, the Fed also restated in even firmer wordings that they expect inflation to moderate later this year and next year. In April, they expected it over the coming quarters.

All in all, the statement showed the stamp of chairman Bernanke, who laid down the body of the decision in speeches two weeks ago when he upped its warnings about inflation (and surprisingly the dollar) and said the downside risks to growth had diminished somewhat. It seems that the chairman and the FOMC want to talk tough on inflation to influence inflation expectations and avoid to have to walk the talk. The FOMC still seems convinced that in the end inflation will moderate. The Fed keeps all its options open and we suspect this to be the case also at the AuAugust meeting and maybe beyond. The eco and inflation data keep all their relevance for further Fed positioning.

Market reaction subdued and “logical”

As the statement was close to Bernanke’s comments of late and even Fisher’s dissent didn’t come out of the bleu the market reaction was subdued. However, the interest rate markets were positioned for a more hawkish outcome and thus when the prospect of an unchanged policy for longer became obvious, yields fell, the short end outperforming and driving the curve steeper. However, the FF futures show that some participants are still counting on an August rate hike. The August FF future trades at an implied 2.075%. The dollar lost some ground against euro and yen. Equities at first were marginally higher, but rapidly reversed the gains. All moves lacked technical significance though.

Fisher keeps dissenting, Plosser rejoins majority

Dallas Fed governor Fisher, a hawk, dissented in favour of a rate increase. It was the third consecutive meeting in which he wanted a more hawkish decision than the majority. The reasoning of Fisher for yesterday’s dissent won’t be known until the Minutes are released or he speaks about it, but in past speeches he clearly elaborated on his views. He fears for an adverse feedback loop in which lower rates weaken the dollar, push commodity prices and inflation higher, which lowers disposable income and so affects consumer spending.

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Published on  Thu, Jun 26 2008, 07:54 GMT

ECB threatens July rate rise

Fri, Jun 6 2008, 14:27 GMT
by KBC Market Research Desk

KBC Bank

• • Trichet suggests rate rise likely next month
  

• • ECB to act as inflation likely to star higher for longer
  

• • Threat of further increases likely to hang over interest rate markets
  

• • ECB adopting a very high risk strategy
  

• • Higher interest rates unlikely to alter food or fuel costs…but could damage a clearly weakening Euro Area Economy
  

Today’s European Central Bank decision to leave its key policy rate unchanged at 4.00 for a twelfth consecutive month did not come as a surprise to financial markets. However, Mr. Trichet’s warning that rates could rise as soon as next month certainly did.

The indication that interest rates could rise a early as next month is probably the biggest shock the ECB has delivered to financial markets in its 9 ½ year history. Traders had looked to the ECB’s monthly press conference for some guidance on the outlook for Euro area interest rates. In the past month or so, hopes for lower rates had all but vanished. Instead, the markets had begun to price in the prospect of an increase in official rates in the Autumn. In these circumstances, investors looked forward to Mr. Trichet’s pronouncement today but there was little expectation of the fireworks he delivered.

The monthly press statement was more hawkish than expected. However, Mr. Trichet went a great deal further in responding to questions than the tone of the opening press statement had suggested. In today’s Q & A session, he said that a number of the ECB council wanted to raise rates today and suggested that the ECB “could move a small amount in July”. While he said it was not certain that rates will rise next month, he made it more than clear that ‘it’s possible to move in July’.

Mr. Trichet went so far today in preparing the market for a rate rise in July that it is difficult to see what would make the ECB decide against hiking rates next month. A failure to raise rates would leave markets completely lost as to what determines ECB policy and communications. Furthermore, the ECB’s much wanted medium term focus means that the vagaries of monthly data between now and the next policy meeting on the 3rd of next month should not dramatically alter ECB thinking. Hence, in sharp contrast to our earlier expectations, it now looks very likely that interest rates are set to rise next month.

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Published on  Fri, Jun 6 2008, 14:27 GMT

A hot inflation summer; can the ECB sweat it out?

Tue, Jun 3 2008, 07:58 GMT
by KBC Market Research Desk

KBC Bank

• • Rising energy and food prices have dramatically changed the short-term inflation outlook and …
  

• • … raise fears about an ECB rate hike around year end
  

• • We however believe deteriorating growth outlook will prevent second round effects from materializing and expect inflation to fall back towards 2% till the end of 2009
  

• • As such, we now expect rates to remain on hold this year and to fall to 3.50% next year

Concerns that the global economy may be facing its greatest inflation threat for decades have dramatically changed sentiment towards interest rates of late. For most of the early part of 2008, the risk of a sharp downturn in global economic activity had underpinned hopes for lower interest rates. However, financial markets now take the view that the risk of higher fuel and food prices spilling over into a more generalised deterioration in inflation will be the dominant influence on Central Banks words and actions. In the US, focus has turned to when and how quickly the Federal Reserve might raise policy rates. In the UK, traders think that stubbornly high inflation will prevent the Bank of England taking action to support a sharp deteriorating Economic outlook. In the Euro area, a rise in ECB rates is now predicted before end year.

Although we think that the prospect of a marked slowdown in the Euro area economic growth remains an issue for the European Central Bank, worries about inflation are an altogether more pressing concern. Unless there is a broadly based deterioration in inflation we still think the next change in ECB policy rates will be a reduction however this is now a far more distant prospect than appeared likely even a month ago. The sharp rise in energy costs in the interim means our earlier expectations of Autumn rate cuts no longer looks plausible. Indeed, there appears little prospect of an ECB rate cut before the end of the year. Instead, in the next couple of months fear about higher ECB rates could well intensify.

Although there has been some easing in oil prices in the past couple of days, the sharp rise from below $90 in the middle of January to $135 in the past weeks has dramatically changed the outlook for Euro area inflation between now and end year. More importantly, the sustained upward pressure on fuel and food costs threaten ‘second round’ increases in the prices of a range of other goods and services. This threat is also reflected in the recent sharp rise in longer-term financial inflation expectations derived from French inflation linked bonds. In recent days, the break even inflation rate derived from bonds with a maturity until 2020/21 set a new high at around 2.60%. In such circumstances, the ECB’s mandate requires that they talk tough and hold out the threat of a further increase in interest rates. The tight relationship between oil prices and financial inflation expectations however also indicates that once oil prices fall, the inflation outlook may clear up pretty soon. Over the past two months, the price of several agricultural commodities, like wheat and rice, have already plunged lower reminding that commodities are no one-way bet. Nevertheless, until the risk of permanently higher inflation diminishes, markets will continue to focus on the possibility of a further increase in ECB rates

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Published on  Tue, Jun 3 2008, 07:58 GMT

ECB: Uncomfortable but unmoved

Fri, May 9 2008, 09:38 GMT
by KBC Market Research Desk

KBC Bank

• • ECB still faces conflicting forces on interest rates
  

• • Trichet continues to emphasize upside inflation threat and downplays growth risks

• • ECB ‘unanimous’ that current policy stance will meet objectives

• • We think easing inflation worries and poorer growth will prompt lower rates in Autumn
  

There was little doubt that the European Central Bank would leave its key policy rates unchanged at 4% following it’s governing council meeting today. Official interest rates have now held steady in the Eurozone for 11 months. As graph 1 below indicates the ECB’s inaction stands in stark contrast to the aggressive measures taken in the US and UK of late. Greater concern about inflation and less fear about economic activity have meant the ECB has not followed the Federal Reserve and the Bank of England.

Comments made by ECB President Jean Claude Trichet at today’s pres conference suggest little likelihood of a change in policy anytime soon. This is not to suggest that the ECB or indeed the Euro area economy is in a comfortable position. Worries about inflation persist, worries which in other circumstances might have led to higher interest rates. On the other hand, the likelihood of a marked weakening in Eurozone activity as 2008 progresses, in different conditions, would argue for a preemptive policy easing. At present, however, the ECB finds itself hemmed in until it becomes completely obvious whether high inflation or low growth is the predominant risk. We discussed the dilemma facing the ECB and the implications for interest rates in some detail earlier this week (ECB Rates, How Far From A Tipping Point?)

Mr. Trichet emphasized today that inflation is still seen as the greater threat at present. The ECB feels extremely uncomfortable about the persistence of high inflation in the Euro area and has taken little comfort from the drop to a 3.3% rate in April from 3.5% in March. Today’s press statement notes that ‘inflation has remained above 3% for the past six months’. To put this in context, inflation previously exceeded 3% in only one month, in May 2001, during the ECB’s stewardship. Today’s statement suggests that the ECB sees inflation ‘gradually declining again’. However, it also argues that ‘in order to ensure that current high inflation rates remain temporary, it is imperative that they do not become entrenched in longer term expectations or lead to broadly based second-round effects in wage and price setting’. So, the ECB remains apprehensive that current price pressures could become permanent.

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Published on  Fri, May 9 2008, 09:38 GMT

Slovakia: Spring EC's forecasts increase the chances for EMU entry

Mon, Apr 28 2008, 14:37 GMT
by KBC Market Research Desk

KBC Bank

The European Commission released its new spring forecasts for 2008 and 2009. We evaluate them as positive for the Slovak aspiration for EMU entry in 2009.

The EC report expects inflation to go materially higher but not only in the Slovakia but also in the eurozone. The Commission raised the Slovak 12-month average HICP inflation from 2.5% to 3.8% in 2008 and from 3.0% to 3.2% in 2009. It basically changed the inflation forecast in the eurozone by the same margin from 2.0% to 2.2% in 2009. Thus, the difference between the Slovak and EMU inflation remains the same in the autumn and spring forecast. Moreover, based on the forecasts for the rest of the EU-27 countries we expect Slovakia will be able to fulfill also the condition of sustainability. The criterion for Slovakia should be 4.1% in 2008 and 3.4% in 2009 (taking into account 3 best performers plus 1.5ppt). That means the country will stay within the required limits also in the foreseeable future according to the Commission’s view. We expect the EC to give a positive assessment for Slovakia next week on May 7th in the Convergence report. The ECB sounded “less friendly” towards the Slovak aspiration for euro adoption in January 2009. The first draft of the ECB report (according to citied rumors) expressed “serious concern” about the development of the Slovak inflation but this view came under strong criticism of other central banks. So, after this pressure from other central banks the Commission forecast now also questions the “less friendly” ECB attitude. We believe that the report will not be too critical in the final stage. Therefore, Slovakia should get the green light next week and adopt the single European currency as planned in January 2009.

This opens a lot of questions about the next possible revaluation of the central parity and final conversion rate. A second revaluation will be logical given the strong productivity differential vis-à-vis the Eurozone and expect it in May. The new central parity could also be the final conversion rate. This issue is a hot topic these days. PM Fico advocates the strongest possible exchange rate that would be in favor of the Slovak inhabitants. Mr Burian from the ruling Smer party (Head of the Parliament Committee for Finance, budget and the currency) said he would expect the conversion rate close the level of EUR/SKK 32.0. Our long standing forecast is EUR/SKK 32.50, but we would not be surprised by a fixing somewhere in the range +/- 50 hellers around 32.0. This makes a possible range of EUR/SKK 31.50 – 32.50. However, one should taking into account that central bank and ECB officials might like to prevent big swings shortly before the revaluation. According to the rumors, the last possible date for the revaluation could be some Friday in mid–June. The Slovak koruna gained around 0.5 percent on the news. We might see some comments from the NBS after the publication of its new quarterly forecast (tomorrow).

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Published on  Mon, Apr 28 2008, 14:37 GMT

ECB signals interest rates won't change anytime soon

Wed, Mar 19 2008, 16:51 GMT
by KBC Market Research Desk

KBC Bank

• • Trichet’s comments broadly similar to those of early March
  

• • ECB says inflation still ‘temporary high’…
  

• • … and ‘economic fundamentals solid’
  

• • So, ECB sees no need to follow rate cuts of other Central Banks
  

• • Trichet does acknowledge greater threat from financial market turbulence
  

• • So, policy on hold for next few months, but …
  

• • We think ECB will be forced into a summer cut and expect interest rates will be 75 basis points lower by year end

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Published on  Wed, Mar 19 2008, 16:51 GMT

ECB downplays chance of early rate cuts

Fri, Mar 7 2008, 09:15 GMT
by KBC Market Research Desk

KBC Bank

• • ECB suggests it is not planning to change policy anytime soon
  

• • Worries about inflation and easing of growth fears mean Trichet sounds less dovish than a month ago
  

• • We still expect rates to fall by 75 basis points by end year

• • Soaring Euro, impact of weak US economy and strains in Spain and Italy will force the ECB’s hand
  

• • We now expect first rate cut in June but wouldn’t rule out earlier move if financial conditions deteriorate or activity data disappoint
  

The European Central Bank kept its key policy rate unchanged at 4.00% for the ninth successive month. Mr. Trichet, the ECB President, used his regular monthly press conference to suggest that the ECB does not intend to alter policy anytime in the near future. In this regard, his main purpose was to deflate market hopes for any near term cut in interest rates.

Mr. Trichet emphasised that the ECB’s focus remains firmly on retaining price stability. Eurozone inflation remained at the record level of 3.2% for a second month in February, some considerable distance above the ECB’s target. So, it will take compelling evidence of a sharp deterioration in Eurozone economic conditions (that would bear down on inflation) before the ECB feels sufficiently comfortable to contemplate reducing rates.

In the wake of Mr. Trichet’s comments today, financial markets take the view that circumstances should change sufficiently to allow the ECB cut rates once in the Summer and probably two more times before end year. We believe that clearer evidence of a sharp weakening of activity and an associated improvement in the inflation outlook should materialise in the next couple of months. As a result, we think the ECB might be forced to cut rates somewhat earlier than the market now envisages. Our expectation that notably poorer economic conditions will develop in the next few months also implies the ECB may have to cut rates as many as three times by the end of the year.

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Published on  Fri, Mar 7 2008, 09:15 GMT

Hungary moves to free−floating FX to fight inflation

Wed, Feb 27 2008, 08:16 GMT
by KBC Market Research Desk

KBC Bank

• • The National Bank of Hungary (NBH) and the government decided to scrap the forint’s trading band and adopt a free-float exchange rate regime in order to focus solely on meeting the medium-term inflation target of 3%
  
• • The inflation outlook contains significant upside risks to the 2009 inflation target and the central bank may have to hike rates to counterbalance these risks, but the forint and bonds may perform well if this strategy becomes credible

The Hungarian government agreed with the central bank to abandon the fluctuation band of the forint on 26 February 2008. The timing of the decision was a surprise for markets as the government didn’t support the idea before. The decisive factor could have been the risk/need of rate hike(s) as inflation has become a major concern for economic policy and as the credibility of the 3% inflation target was at stake.

The conflicting dual inflation and exchange rate targets have been mentioned by many observers as a possible source of instability. The IMF, economic think tanks and many economists argued in recent years that Hungary would be able to achieve low inflation easier without the band.
The band was introduced as part of the Bokros Austerity package in 1995 and was widened to +/-15% in 2001, when the central bank adopted the inflation targeting framework.

Low credibility of the inflation target

Inflation has accelerated to above 7% since last autumn, in line with the trend of other CE4 countries. However, there have been signs that inflation has not just risen on one-off shocks, like food, fuel or regulated prices, but that also services and tradable goods showed some acceleration in recent months. The underperformance of the forint and of the long end of the local government bond curve were a signal that markets feared the inflation shock was not just temporary, but that part of that could become a permanent development.

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Published on  Wed, Feb 27 2008, 08:16 GMT

A giant leap for the ECB, a small step towards lower interest rates

Fri, Feb 8 2008, 10:58 GMT
by KBC Market Research Desk

KBC Bank

• • ECB calls off threat ‘to act pre-emptively’ against higher inflation
• • Mr. Trichet acknowledges increased threat of weaker growth
• • Comments provide ECB with leeway for early rate cut if needed
• • March reduction can’t entirely be ruled out but April/May reduction now looking more likely
• • ECB may cut interest rates 3 times in 2008

While the European Central Bank kept its key rates unchanged today, comments made by its president, Jean Claude Trichet, will serve to increase expectations that the ECB could cut rates in the not too distant future. As a first step, Mr. Trichet stood down the threat of further rates increases which the ECB had signalled every month since it last raised rates in June 2007. In addition, the tone of Mr. Trichet’s remarks, which emphasised concerns about weak growth and repeatedly alluded to a determination not to precommit on policy, will sustain the possibility that rates could be reduced within a matter of months if poorer economic conditions were to warrant such action.

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Published on  Fri, Feb 8 2008, 10:58 GMT

Another difficult balancing act for the ECB

Thu, Feb 7 2008, 08:36 GMT
by KBC Market Research Desk

KBC Bank

• • ECB still pressured between rising inflation and weaker growth, but...
  
• • …Inflation peak in February and weak Q4 GDP growth data may increase room for manoeuvre from March meeting onwards
  
• • We still see two rate cuts by 25 bps in March and June
  

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Published on  Thu, Feb 7 2008, 08:36 GMT

What Will the Czech Central Bank Do About 7% Inflation?

Wed, Jan 30 2008, 14:17 GMT
by KBC Market Research Desk

KBC Bank

• • Czech January inflation will approach 7%, hitting a 9-year high.
  
• • The National Bank’s new inflation forecast is likely to be more pessimistic in the short term, while more positive for the next 12-18 months.
  
• • The inflation shock should temporarily increase expectations for more aggressive hikes in rates, pushing the koruna to new all-time highs.

In the last quarter of 2007, we were confronted with numerous unpleasant inflation surprises, but this is not the end of the influx of unfavourable figures. The greatest inflation shock may still occur as early as February 8, when January’s inflation, which we put at nearly 7%, will be released. Paradoxically, the CNB Bank Board will discuss interest rate settings the day before.

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Published on  Wed, Jan 30 2008, 14:17 GMT

The Bank of England cuts rates, but the ECB signals no early easing

Fri, Dec 7 2007, 08:52 GMT
by KBC Market Research Desk

KBC Bank

While the Bank of England cut interest rates by 25 bps in the face of the credit turmoil, the ECB left rates unchanged and struck a quite hawkish line at its press conference. We think a range of factors prompted Mr. Trichet to sound hawkish today, but remain of the view that ECB policy rates will fall to 3.5% by next Summer.

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Published on  Fri, Dec 7 2007, 08:52 GMT

EU Commission spring economic forecasts

Tue, May 15 2007, 09:53 GMT
by KBC Market Research Desk

KBC Bank

• Public finances benefit from upward revision EU Commission growth forecasts
• Strong investor’s risk appetite to keep spreads tight, despite rising yields

The EU Commission Spring forecasts highlighted the strong economic performance of the euro zone economy in 2006 and solid outlook for 2007 and 2008. Compared to the Autumn forecasts, the Commission has revised up its growth forecasts and now expects economic growth to remain above potential in the next two years.

In 2006, the economic expansion was increasingly driven by domestic demand, especially by a marked improvement in investment in equipment. Private consumption grew more moderately, but is expected to accelerate as the labour market started to improve considerably. Following the 2.7% growth pace in 2006, annual growth is forecasted at 2.6% in 2007 and 2.5% in 2008 upwardly revised from 2.1% and 2.2% in last year’s Autumn forecasts.

On the back of the economic improvement, public finances improved markedly last year with the general budget deficit falling from 2.5% in 2005 to 1.6% of GDP in 2006. This positive trend is set to continue with the euro zone budget deficit forecasted to fall further to 1% in 2007 and 0.8% in 2008. In structural terms, corrected for cyclical factors and net of one-off and other temporary measures, the budgetary adjustment in the euro area is however more muted than the nominal improvement. At the same time, the debt ratio also continued its decline that started in 2006. Between 2005 and 2008, the debt ratio is expected to fall from 70.5% to 65% of GDP.

The table (cf. below) provides an update of the new growth and deficit/debt forecasts for the individual euro zone member states. The member states are ranked in order of their projected debt-to-GDP ratio. Since the modification of the Stability and Growth Pact (SGP) in March 2005, market attention for the national budget situations has increased. The loss of credibility of the SGP resulted in a significant underperformance of mainly Italian, Greek and to a lesser extent also Portuguese bonds, as these countries faced the strongest deterioration in their fiscal position in recent years and already had the lowest rating among the euro zone member states. Last year, S&P and Fitch downgraded Italy’s rating from respectively AA- to A+ and from AA to AA-, as the new government failed to implement rigorous measures in their first budget. Since, the improvement in public finances has put Greece on a positive outlook at Moody’s and Fitch and has upgraded the negative outlook of Portugal to stable at Fitch.

From the countries under the excessive deficit procedure (EDP), the 2006 outcomes confirm that the deficit has been brought below the 3% of GDP threshold in both Greece and Germany. In Greece, the forecast is still based on the old GDP series and not yet on the ‘revised’ GDP data reported by the Greek authorities. Using the latter would lead to an upward revision of nominal GDP by around 26% per year. This would reduce the deficit to just below 2% of GDP, but as this would lead to a permanent increase of Greece’s contribution to the EU budget, the Commission estimates the budget deficit would rise again to close but below 3% of GDP.

A better than expected reduction of the deficit was also achieved for Portugal and Italy (net of a large deficit increase one-off). In the case of Italy, the budget deficit is expected to fall below 3% of GDP in 2007. In Portugal, however, the deficit is still projected to remain above the 3% of GDP throughout the forecast period. Concerning the debt-to-GDP ratio, the upward trend has reversed for all countries except Portugal, where the debt is expected to increase slightly. As such, Portugal won’t meet the requirements of the excessive deficit procedure to correct its excessive deficit by 2008 without additional measures.

Among the countries that do not have the highest credit rating in the euro zone, Belgium is still doing rather well,even while Eurostat amended the budget deficit from a surplus of 0.1% to a deficit of 2.3% of GDP in 2005 in relation to a debt assumption from the railway company. Despite the government’s commitment to publish budgets in balance, the Spring forecast project the Belgian budget deficit to widen to 0.1% of GDP in 2007 and 0.2% in 2008 from the 0.2% surplus in 2006. The debt ratio, while still the third highest within the euro zone member states, is projected to remain on a firm downward path and to fall to 82.6% of GDP in 2008.

To assess the budgetary outlook, it is also important to keep a close eye on the general trend in yields. Shortterm yields have risen quite substantially since the start of the ECB tightening cycle in December 2005. At the longer end of the curve, the rise in yields was less outspoken, as the curve flattened. The rise in yields is mainly important for countries with a high debt-to-GDP ratio like Italy, Greece and Belgium, as this may have a large influence on interest expenditures and consequently budget deficits. The outlook for the spreads between government bonds will however heavily depend on the general risk appetite. Until now, the rise in ECB rates did not spoil investor’s risk appetite yet. On the contrary, on the corporate bond market spreads are still very tight. This may keep spreads tight between euro zone government bond yields too, despite the strong improvement in public finances in for example Germany.

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Published on  Tue, May 15 2007, 09:53 GMT

February payrolls report still more important than usual

Thu, Mar 8 2007, 15:28 GMT
by KBC Market Research Desk

KBC Bank

• Recent correction in equity markets ups the importance of the February payrolls
• Payrolls may have been negatively influenced by the weather
• Risks seem to be on the downside of expectations though

Why are payrolls so important?

The US payrolls report is traditionally the most influential data release for financial markets. It gives a very timely and comprehensive view of developments in the most important economy of the world.

It shows how activity fared in various sectors (retail, services, housing, manufacturing). Combining payrolls and hours worked, it gives a rough estimate of growth. It contains indications about wages (and so inflation) and, of course, allows measuring the tightness of the labour market.

All these and other elements together also allow to judge how monetary policy may evolve further out.

The February report may be still more important, as currently the markets of riskier assets, are very shaky. While a re-assessment of risk is probably the main factor behind recent corrections, there are re-surfacing doubts too on the outlook of the economy and the kind of landing we may expect. Should the report point to increased risks of a harder landing, the recent correction in risky markets may get a second leg. On the other hand, a strong report may ease these fears, but is problematic for bonds that profited so much in the recent correction.

What partial indications are available?

The most important factor may turn out to have been the weather conditions. In the previous months the weather has been un-seasonally mild (warm and dry) and so favourable for the economy and the labour market, but in February, the weather turned unfavourable (cold and wet). This change in the weather between the January and February survey weeks might have affected activity in a number of sectors negatively.

The construction sector is the first that springs in mind.

Construction payrolls rose by 22 000 and 10 000 in January and December at a time when the number of houses under construction fell. While non-residential investment is doing well, these figures are clearly upwardly distorted by the weather. So a sharp pull back in construction payrolls in February is likely, as also the underlying trend in housing is sharply down. There may also be a weather-negative effect in professional & business services and its subgroup of temporary help agencies that performed (too) good recently.

Besides the weather-related part of the story there may be some genuine trend-like slowing in employment growth.

Despite a somewhat better ISM survey, it is clear that the sector is having problems and that should result in another drop in manufacturing payrolls of slightly less than 20 000, about the number of job losses in previous months. There may be some upside risks to these expectations as the ISM employment index edged up to 51.1 from 49.5 previously.

Forecasters are looking to some partial labour market indications for clues about the payrolls results.

The relevant initial claims results show a sharp rise of the initial claims between the January (287 000) and the February (331 000) survey weeks. Maybe more important, the continuing claims rose about 160 000 in the same interval.

The strike activity data show that about 2800 workers started to strike in February, not so relevant in the broader context.

The Non-manufacturing ISM employment index edged marginally higher to 52.2, but more importantly it remains at low levels.

ADP employment report points to weakness

The ADP report showed private sector employment increasing by 57K in February below the expected 100K and below the downwardly revised increase of 121K in January.

This may point to a rather weak Payrolls report on Friday, even if one takes into account that the ADP report makes abstraction of payrolls growth in the public sector, which is usually good for 15-20K job growth. As such, the ADP report is consistent with a Payrolls report of about 75K, which is still below the current Bloomberg consensus of 95K.

Other details in the report

While the payrolls are the most important part of the report, market reaction may be coloured by a number of other data from the report. The unemployment rate should stabilize at 4.6%, after moving higher in January. The cyclical low of 4.4% was reached in October 2006. While a gradual rise of the unemployment is likely, it is unlikely there would again be a rise this month.

The underlying trend in average hourly earnings is about 0.3% M/M, but in January they rose only 0.2% M/M, but this followed a 0.4% M/M increase in December. So, the most likely result is a 0.3% M/M increase. However risks are on the upside, as the weather-related loss in payrolls might disproportionally affect lower paid workers, pushing the average higher.

Forecasters struggle with February payrolls

Forecasters have traditionally done a bad job in forecasting the February payrolls. The standard error has been the largest on the entire year, even surpassing the January month, also a difficult one. Weather is the most likely culprit. In the past, most of the time payrolls came in above consensus, but since 2000, there were three large below consensus and four small above consensus outcomes.

Conclusion and market reactions

The consensus estimate of 95 000 is slightly below January’s 111 000, with the complete range between +40 000 and +150 000. There are some reasons to put the risks on the downside. The consensus expects the unemployment rate to be unchanged at 4.6% and average hourly earnings to be up 0.3% M/M. We have no reasons to deviate from consensus on these.

Equity markets could use a decent number to put its woes behind and establish gradually a better sentiment. At this stage, interest rate considerations seem to us less important than usual. So in case of a weak figure, equities might have a difficult time, even if interest rates go lower.

Regarding currencies, there looks to be an asymmetrical risk. A weaker payrolls report should do more harm to the dollar than a good report might benefit it. Especially for USD/JPY, we are interested to see whether a weak report might push the pair below 115.16. This might trigger another round of unwinding of carry trades.

Bonds had a strong run recently and so need a weak figure to safeguard these gains. Whether there is already much upside will probably depend on equities. If these fall sharply, there might still be some more upside. If not, then a weak report should lead to only moderate gains. For the June Note future, the highs at 109-18+ or the 4.40% on 10-year yields looks a hard nut to crack and a test might generate some profit taking. A steepening of the curve is more likely.

In case of a strong figure, we might get some decent profit taking.

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Published on  Thu, Mar 8 2007, 15:28 GMT

ECB to raise rates to 3.75%

Wed, Mar 7 2007, 14:52 GMT
by KBC Market Research Desk

KBC Bank

• ECB to hike rates 25bp to 3.75% for the seventh time this tightening cycle
• 2008 inflation projections will take centre stage regarding the outlook for interest rates
• Strong growth outlook and buoyant money supply growth will indicate inflation risks lie still on the upside
• Recent financial turmoil unlikely to change ECB interest rate policy
• Central scenario for a further rate hike to 4% by June still in place
• But fears about US/global economic outlook introduce an element of uncertainty

At its March policy meeting, the ECB Governing Council is widely expected to raise rates by 25 basis points to 3.75%. Main attention will however go out to the press conference for some guidance on the outlook for ECB interest rates beyond the March rate hike. In this context, the publication of the new Eurosystem staff projections may play an important role.



 ECB ready to hike rates again


 By re-introducing its vigilance mantra at the February policy meeting, ECB’s president Trichet paved the way for another increase at its next meeting in March. This will be the seventh rate hike this tightening cycle and bring the main refinancing rate to 3.75%. Whether the increase will be followed by more rate hikes will mainly depend on the data, as rates have entered the so-called neutral range in the euro zone, which we see between 3.50% and 4%. As such, the ECB is likely to adopt a similar stance as in December when it promised to ‘monitor very closely’ all developments but stopped short of explicitly hinting at another increase by dropping the phrase that ‘if our assumptions and baseline scenario continue to be confirmed, it will remain warranted to further withdraw monetary accommodation’. Recent solid eco and buoyant money supply data nevertheless suggest the ECB is likely to hold on to its tightening bias even beyond the March rate hike.



 2008 inflation projections take centre stage in new staff projections


 At the February policy meeting, Trichet emphasized the difference between the short-term and medium-term inflation outlook in the euro zone. While inflation in the short-term is not expected to move back above the 2% level, Trichet stressed that the risks on the medium term still lie on the upside. This message is likely to be confirmed in the new Eurosystem staff projections. According to the FT, the new staff projections will show a downward revision of the inflation projections for 2007 from 2% to 1.8-1.9%, but also a slight upward revision of the 2008 inflation projection of 1.9%. The latter may strengthen the case for the ECB to raise rates further to 4% in the course of this year given the ECB’s focus on the medium term outlook. At the same time, the expected upward revision of the growth projections for 2007 and 2008 from respectively 2.2% and 2.3% will underscore the upward inflation risks inherent to the economy, even if the 2008 inflation projection would remain just below 2%. In this context, it’s worth mentioning that the ECB has always pursued a tightening bias as long as the manufacturing PMI stayed above the 55-level, even when the headline inflation rate hovered below the 2% level.



 Money supply growth supports tightening Bias


 The ECB also suggests that the upside risks to price stability are also highlighted by the monetary analysis. Even while recent interest rate rises eased household borrowing, M3 money supply growth is still accelerating and is currently running at a 17-year high. This may still pose some inflationary risks in the medium to longer term given the longterm relationship between money supply growth and inflation. As such, even while higher interest rates may have started to affect the real economy, buoyant money supply growth is still likely to remain a cause for concern for the ECB for a longer period of time. The rather uncertain relationship may however refrain the ECB from giving too much weight to this issue, the more if the economy would start to slow.



 Financial turmoil unlikely to have changed ECB policy


 Recent financial turmoil may make Trichet somewhat more guarded in providing guidance on the outlook for ECB interest rates, but is unlikely to have changed the ECB interest rate policy profoundly. We therefore mainly refer to how Trichet has handled last year’s May/June correction on the financial markets, which was very similar to what we have seen up until now. During the June press conference, Trichet considered the correction ‘as a normal correctional phenomenon’ and added that ‘the re-appreciation of risks in the financial markets in a way also corresponds to a view of the Governing Council’, as the ECB and other central bankers within the G10 think that ‘there has to a certain extent been an underpricing of risks in the global financial markets’. He even added that ‘if this pricing were to increase somewhat, it would perhaps be going in the direction of an improved pricing of risks’. His comments at the latest press conference in February suggests that the view of the Governing Council did not change since, as Trichet again expressed his concern about the ‘under-appreciation of risks’ and reckoned that this is ‘probably a transitory period’ and that we will have ‘over time an increase in the pricing of risks that will be more in line with a good and appropriate assessment of risks at the global level’. As such, the recent financial turmoil may to a certain extent be a welcome development that won’t change the outlook for interest rates profoundly. This view contrasts a bit with the US, where Bernanke already hinted that if the financial turmoil would continue, the Fed may come to the rescue. In the euro zone, such an approach should not be expected in the short term.



 Markets scale back interest rate expectations


 Even while the recent financial turmoil won’t change the ECB policy profoundly, markets have scaled back their interest rates expectations quite significantly in recent weeks and currently attach only a probability of about 40% to a rate hike to 4% by June and 50% by September. This move can be partly explained by the safe haven flows, that usually favour the short end of the curve, but rising fears about the outlook of the US economy and consequently the euro zone economy played a role too. The outlook for the US economy and its potential spill over effects towards the euro zone economy is currently the main risk concerning to our main scenario for another rate hike to 4% by June.



 Conclusion


 At its March policy meeting, the ECB is widely expected to raise rates to 3.75%. Even while further rate moves will be data dependent, we still expect the ECB to hold on to its underlying tightening bias given the upside risks to price stability related to the solid growth outlook and buoyant money supply conditions. Recent financial turmoil may make Trichet somewhat more guarded in providing guidance on the outlook for rates, but is unlikely to have changed the ECB interest rate policy profoundly. A further significant slowing of the US economy is currently the main risk towards our scenario for another rate hike to 4% by June  

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Published on  Wed, Mar 7 2007, 14:52 GMT

Tricky January Payrolls?

Thu, Feb 1 2007, 14:42 GMT
by KBC Market Research Desk

KBC Bank

• Payrolls growth kept up well in previous months and should have done so in January too
• However, January payrolls contain an unusual high number of special factors, also of statistical nature
• Manufacturing sector probably continued to shed labour, but services compensate

Payrolls surprise positively

The economy slowed in Q2 and Q3, before posting a better performance in Q4. The jury is still out whether the Q4 result is due to special factors like weather conditions and the drop in energy prices or the start of an improvement in the underlying trend. With growth in Q2 and Q3 below trend one would expect payrolls growth to have slowed too. However, with exception of October 2006, payrolls growth exceeded 100 000 in each other month of last year. Moreover, if anything, the underlying trend even strengthened marginally, as the 6-month average stood at 161 000 in December, slightly above July’s 146 000. For the whole of 2006, a net 1.838 million jobs have been created, only slightly less than the 1.981 million in 2005 and the 2.097 million in 2004. Some time ago some Fed governors suggested that the slower growth would be reflected in a weaker labour market with a time lag that might be longer than usual. Chicago Fed Moskow, but also others, suggested that the monthly growth of the labour force might be no higher than 100 000 to 125 000. This means that the labour market even tightened slightly, and if payrolls growth would accelerate it could create inflationary pressures via wages. However, an offsetting factor has appeared in the form of a rise in the labour participation rate that rose from 66% in early 2006 to 66.4% in December.

Goods versus service sector

While overall payrolls held up well, there is a divergence growing between the goods producing and the service producing sectors. Starting with the former, payrolls growth in the manufacturing sector fell continuously since last July. In December the decline slowed to 12 000, but it is too early to look for a durable improvement. All four regional PMI surveys showed a worsening in employment conditions in January. While the ISM, to be released later today, may still influence our view, it is likely the manufacturing continued to shed jobs in January.

The construction sector started to lose jobs since September of last year. In December, the decline was minimal, probably due to the better weather conditions. The sharp slowing in the residential sector will continue to affect construction payrolls negatively. Of course, this only happens with a large time lag, as started constructions will have to be finished. However, the slowing in starts is now affecting the payrolls.

The very mild weather conditions in early January might hide the underlying deterioration. Every January, about 320 000 workers fall out of the payrolls on a non-seasonally adjusted basis. Given the weather, there should be less this year and this might result in a rise of (SA) construction payrolls. The labour market conditions kept up better in the service-producing sector, which might be partially explained by the less cyclical nature of the sector. The importance of this sector has grown steadily in the last few decades if compared to the goods-producing sector. Service payrolls growth kept up very well. Encouraging, payrolls at Temporary Help Agencies, a subsector that has a leading character, stabilized in recent months following some decline previously. Retail payrolls are always an important issue in the January report, as many workers are laid off after the Christmas shopping season (about 700 000 on a NSA basis). As the hiring of these was tepid in December, there might be less lay-offs in January, resulting in a strong rise of (SA) retail payrolls.

Other reports favourable too

The ADP report revealed a 152 000 gain in private payrolls in January, following a surprise (but distorted) 40 000 increase in December. Taking public sector employment growth in consideration, this would translate in a rise in payrolls of about 170 to 175 000. Initial claims in the payrolls survey week amounted to just 290 000, down from 316 000 in the survey week for the December report. While the weather might have distorted the claims figure, the same might have happened in the payrolls.

Statistical pitfalls

In January the statisticians of the BLS revise the payrolls for a number of specific reasons. Firstly, there is the annual benchmarking for the period of April 2005 to March 2006. In October, the BLS put provisionally the revision at + 810 000, but it seems to be slightly lower. This will raise the level of payrolls of March 2006, but also the various months since April 2005. Secondly, there is the postbenchmark revision of the data between April 2006 and October 2006 and the usual revision for the two most recent months on the basis of the late responses of the respondents. The BLS will also incorporate new estimates for the population into the data from the household report.

Forecasters have difficult job

Forecasters have a very difficult job when looking to the January data. The huge seasonal adjustment factors and the high number of revision have resulted in a very bad track record for the January payrolls, the second worst of the year (after February). In the previous 10 years, the standard forecast error for January is 123 000, sharply higher than the average standard error (82 400).

Conclusion

The January payrolls report should be a good one, supported by a number of special factors. Our bias is for an above-consensus estimate. However, there are so many statistical issues that it might be a complete surprise in both directions. Forecasters have traditionally done a lousy job in forecasting the results. It will also be very difficult to interpret the figures on the release itself. This might also impact market reactions and turnarounds in directions some minutes after the release are a possibility.

Market reactions

In the bond market, the sell-off that started in early December has reached some critical technical levels. There were some signs yesterday that the sell-off phase is over for now. The stronger Q4 GDP failed to push Treasuries lower and after the FOMC statement, a small short covering rally took place. With rate cuts almost priced out, also from a fundamental point of view, the market is better positioned. However an iron-strong report might be the final straw that breaks the Camel’s back and kill the latest hope on a rate cut. More likely, if the report is weak, a short covering rally in an oversold market may take place. Even an as expected report might help Treasuries creep away from these key levels in a corrective move.

Regarding the dollar, EUR/USD is currently in a 1.2865 to 1.3050 range. While we are close to the top of the channel, we are sceptical whether the payrolls report has the ability to push the currency out of this band in a sustained fashion.

Published on  Thu, Feb 1 2007, 14:42 GMT

More favourable euro zone inflation outlook unlikely to withhold the ECB from raising rates further

Mon, Jan 29 2007, 17:39 GMT
by KBC Market Research Desk

KBC Bank

• Euro zone headline inflation unlikely to move above 2%, as drop in oil prices offsets German VAT increase
• ECB staff projections for inflation likely to be revised down, but growth up
• ECB to stress growth outlook/excess liquidity to explain the case for higher rates
• Still two more rate hikes expected this year

Until recently, euro zone headline inflation was widely expected to rise back above the 2% target in the beginning of 2007 largely due to the German VAT increase. The risk of an associated rise in wage demands and some deterioration in inflation expectations was seen underpinning further tightening in policy by the European Central Bank. However, a couple of recent developments appear to have made the immediate inflation outlook somewhat less threatening. In turn this has implications for Eurozone interest rate outlooks.

German VAT to push inflation higher, but…

Initial fears about a likely acceleration in inflation in early 2007 were centred on sharply higher indirect taxes in Germany. On the 1st of January, Germany increased its VAT by 3pp from 16% to 19%. This will have a considerable impact on the inflation data for Germany and also the euro zone. The German VAT increase was expected to add 0.3-0.4pp to euro zone headline inflation. All other factors constant, this would cause euro zone headline inflation to rise from 1.9% Y/Y in December to 2.2-2.3% Y/Y in January.

However, in recent months there were signs that some of the VAT increase had already been passed through in late 2006. It may also be expected that not all of the increase will be passed through in January, but that some of the increase will only become visible in February or even March. The discounting of old stock in post Christmas sales meant that some retailers might delay implementing the increase until new 2007 ranges of goods are put on the shelves in February or even March. These timing issues are compounded by indications that some retailers and suppliers are being forced to absorb the tax increase rather than pass it on to customers. So, while regulated prices will mechanically reflect the tax hike, sluggish retail sales mean the final impact of the tax increase may have less of an impact on inflation than initially feared.

Plunging oil prices offsetting factor

At the same time, the recent drop in oil prices as well as a favourable base effect will have a large downward impact on euro zone inflation. Last year, energy prices rose a very strong 2.4% M/M in January, which will now fall out of the calculations. According to the ECB, the favourable base effect is expected to reduce the annual inflation rate by 0.4pp from January to July 2007. In stark contrast to last year, oil prices have plunged by more than 10% in euro terms between December 2006 and January 2007. This is likely to reduce annual inflation by a further 0.1-0.2pp although this impact may take several months to feed through fully to consumer prices.

Taking into account these factors, this suggests some downward risk to the current inflation consensus for January of 2.1% Y/Y. More fundamentally, it suggests that the inflation outlook in the first half of the year will be far less worrying than first thought, which may also have its implications for ECB monetary policy/strategy going forward.

ECB to revise inflation forecast lower, but growth higher

In December, the latest ECB staff inflation projections were revised down rather significantly and showed inflation likely to come out at 2% in 2007 and even slightly below 2% in 2008, which would be in line with the ECB’s definition for price stability. In the next staff projections, which will be published in March, inflation could be revised down further making it somewhat more difficult for the ECB to continue raising rates, even at a slower pace. However, recent ECB comments suggest that the drop in oil prices as well as some better US eco data have also improved the euro zone economic outlook. Today, ECB’s Liebscher hinted at an upward revision of the growth projections by saying that ‘he is more optimistic on the euro zone economy now than in December’. An upward revision of the growth projections will push euro zone growth clearly above potential, which is usually seen at around 2%. This will keep the ECB eager to bring rates somewhat higher in what we consider as the zone of neutral rates between 3.50% and 4%. The Survey of Professional Forecasters, which will be published in the February monthly bulletin may provide a first idea of where the new ECB projections may come out.

ECB talk to shift towards growth

The more favourable inflation outlook may thus require a shift in communication by the ECB. Until now, the ECB has always stressed the importance of the headline inflation number and has argued that the core inflation rate is likely to follow changes in the headline inflation rate over time.

Instead, the headline inflation rate has fallen of late, while the core inflation rate has barely moved. So the underlying inflation picture has not been as threatening as the ECB might have expected. But it must be emphasized that this more favourable outcome has not materially altered ECB thinking on the need for further increases in interest rates. As such, we expect the ECB to put more stress on the growth outlook to explain the case for higher rates. The first signs of this are already evident, as ECB’s Bini Smaghi last week said that ‘if growth expectations are confirmed, the ECB needs to raise rates more to avoid excess liquidity’. ECB Governing Council members still describe monetary policy as ‘accommodative’ or even ‘very accommodative’. As long as the growth outlook remains strong, the ECB will continue to question whether rates should still be accommodative, even though the immediate inflation threat has lessened.

Money supply growth keeps ECB alert

This argument is closely linked to the monetary pillar of the ECB monetary policy concept, as the ECB fears that ‘ample liquidity’ conditions in the euro zone will pose an upside risk to inflation in the medium to longer term. Solely based on monetary indicators the ECB in June of last year projected euro zone headline inflation to remain above the 2% until 2009. As since then monetary indicators have remained buoyant, upward inflation risks stemming from money supply growth have not lessened but have increased further.

In these circumstances, the ECB is likely to take little comfort from the favourable inflation outlook for the first half of the year and will continue to stress upside risks on inflation related to the strong growth outlook and buoyant money supply growth. From the second half of the year, the base effect from oil prices will turn unfavourable and is expected to add around 0.5pp to euro zone headline inflation from August to November 2007. As such, as long as the growth outlook remains strong, one may still expect the ECB to raise rates more than the widely expected hike in March.

Inflation expectations ignore fall oil prices

Importantly, in this context, it’s also worth noting that financial market’s inflation expectations have also taken little comfort from the drop in oil prices, as inflation expectations did not track the drop in oil prices, but remained rather sideways oriented around the 2.15% level in line with price stability.

Conclusion: two more rate hikes still likely

In conclusion, the more favourable than expected inflation outlook for the first half of 2007 is unlikely to change the interest rate outlook of the ECB profoundly, but may require a shift in communication putting more importance on the growth outlook. As long as growth remains strong, two more rate hikes are still expected this year. In this sense policy is somewhat more data dependent. In the months ahead, growth data will hold the key to when and at what level the ECB feel they can ‘pause’ in the tightening cycle.

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Published on  Mon, Jan 29 2007, 17:39 GMT

EU commission autumn economic forecasts

Fri, Nov 24 2006, 16:44 GMT
by KBC Market Research Desk

KBC Bank

EU COMMISSION AUTUMN ECONOMIC FORECASTS

In this Flash, we provide an update of the EU Commission’s economic forecasts for the euro zone and look into the latest national budget data and their possible impact on government bond spreads.

The EU Commission autumn forecasts highlighted the strong economic performance of the euro zone economy in 2006 and its favorable implications for public finances. Indeed following years of below trend growth, the euro zone economy finally gathered pace in 2006. Sustained strong global economic conditions and increased domestic demand, especially in investments were the main drivers. The recent improvements in the labour market should now also result in a recovery in consumer spending, keeping the economic expansion ongoing. This positive outlook is reflected in the EU Commission forecasts for GDP growth, which project growth to remain at around trend in 2007 and 2008 at respectively 2.1% and 2.2% in the euro zone.

The improved economic conditions are also reflected in the public finances, as higher growth boosted tax revenues. As such, the average budget deficit is seen at 2% of GDP this year, down from 2.4% in the euro area, and at 1.5% in 2007 and even 1.3% in 2008. At the same time, the debt-to-GDP ratio is also expected to decline following the peak at 70.6% in 2005. Over the forecast period, the euro zone debt ratio is projected to decline to 66.9% in 2008.

The improvement in public finances resulted in an outperformance of euro zone government bonds in the course of 2006. As a result, the spread between German government bond 10-year yields and swap rates widened from around 10 basis points in 2005 to around 25 basis points currently.

Strong improvement in public finances leads to a widening in the spread between government bond yields and swap yields.

The table (cf. below) provides an update of the new growth and deficit/debt forecasts for the individual euro zone member states. For the first time, Slovenia is included in the table, as Slovenia will join the euro zone from next year on. The member states are ranked in order of their projected debt-to-GDP ratio.

The table replicates for most member states the improvement seen in the general euro zone figures. As a result only two member states are projected to run a deficit of more than 3% in 2006 compared to four in 2005. Indeed, following several years of excessive deficits, Germany’s and France’s budget deficit is expected to fall below the 3% of GDP this year. As such, only Italy and Portugal are still running an excessive deficit in 2006. But also in these two countries, the deficit is on a downward path. In Italy, the deficit is even projected to fall below 3% of GDP in 2007. Concerning the debt-to-GDP ratio, the upward trend in many euro zone member states is expected to reverse over the forecast period. Only in Portugal, the debt ratio is still on a rising path. Given the gradual improvement in the debt ratio, the number of member states with a debt ratio of above the 60% of GDP reference value will decline from seven this year to six in 2008.

Since the modification of the Stability and Growth Pact (SGP) in March last year, market attention for the national budget situations has increased. The loss of credibility of the SGP resulted in a significant underperformance of mainly Italian, Greek and to a lesser extent also Portuguese bonds, as these countries faced the strongest deterioration in their fiscal position in recent years and already had the lowest rating among the euro zone member states. Mid- October, S&P and Fitch even downgraded Italy’s rating from respectively AA- to A+ and from AA to AA-, as the new government failed to implement rigorous measures in their first budget. Both rating agencies have now a stable outlook, even while S&P was much more criticizing the fiscal situation, which is also reflected in the lower absolute rating.

From the countries under the excessive deficit procedure, Portugal is clearly the ugly duck. Despite the overall economic upturn, economic growth in Portugal remained rather sluggish. This kept the rise in revenues rather limited compared to other euro zone member states. As a result, the budget deficit is projected to remain substantially above the 3% limit throughout the forecast period. As such, Portugal won’t meet the requirements of the excessive deficit procedure to correct its excessive deficit by 2008 without additional measures. The weak performance is also reflected in the debt ratio, which is still on an upward track and is projected to exceed the 70% level by 2008 compared to only 58% in 2004. The negative outlook should still result in an underperformance of Portuguese government bonds compared to its peers. Do not forget in this context that Fitch does still have a negative outlook for Portugal.

Besides Portugal, also Italy is struggling to bring its budget deficit below the 3% level on a sustainable basis. This year, the budget deficit is even expected to rise to 4.7% of GDP from 4.1% in 2005 following a court ruling demanding the refunding of unduly paid VAT for company cars. In the draft budget for 2007, Italy nevertheless targets a deficit below 3%, as required by the excessive deficit procedure. Whether this will be achieved is still rather uncertain, as it is difficult to anticipate the revenues stemming from the measures aiming to fight tax evasion. The autumn forecasts nevertheless project the Italian budget deficit to fall below the 3% level in 2007, but to rise again slightly above this level in 2008. The debt ratio remains the highest of the euro zone member states and won’t fall below 100% throughout the forecast period. As such, Italian public finances remain very vulnerable in case of a rise in the general interest rate level. The greater commitment of the new government Prodi nevertheless resulted in some outperformance of Italian government bonds, even despite the recent rating downgrade.

Greece on the other hand is doing rather well following the significant upward revision of the budget deficit to 7.8% in 2004, due to an accounting scandal and a spending spree related to the Olympic Games. Since, the budget deficit is on a downward path and is now projected to decline to just above the 2.5% of GDP this year in line with the recommendation of the excessive deficit procedure. Despite the improvement in the deficit, the debt ratio is still way above the 60% of GDP reference level and is only projected to decline gradually to below the 100% in 2008. These figures, however, do not take account yet the recent significant upward revision of Greek’s GDP by 25% following the incorporation of the black economy in the data, as Eurostat still has to verify the sources and methods used by Greece. Nevertheless since the top in April, the spread between Greek and German 10-year yields has narrowed from 35 basis points to around 25 basis points currently. The fact that the spread is similar to Italy can be explained by the lower rating.

Also Germany is on track to correct its excessive deficit, as its budget deficit is projected to fall below 3% of GDP in 2006 for the first time since 2002. The major contribution to this improvement comes from the revenue side, thanks to the strong growth upswing. In 2007, the budget deficit is even projected to fall to 1.6% of GDP, as the VAT increase should boost revenues by 1% of GDP. The improvement has already led to a reduction in its borrowing plans this year by EUR 5 B and in 2007 German net borrowing requirements are expected to fall further from EUR 30 B this year to EUR 22 B. The impressive improvement in German public finances is likely to support German government bonds and may lead to a further widening of the spread between German yields and swap rates.

In contrast to what had been projected in the EU Commission spring forecasts, France’s budget deficit is likely to remain below the 3% level in 2006 for the second consecutive year. As such, the excessive deficit procedure will not be reopened. On the contrary, in the coming years the deficit is likely to remain on a downward path to come out at 2.2% of GDP in 2008. However, as this result is less impressive than in Germany, spreads may remain in slight positive territory.

Among the countries that do not have the highest credit rating in the euro zone, Belgium is still doing rather well, even while Eurostat amended the budget deficit from a surplus of 0.1% to a deficit of 2.3% of GDP in 2005 in relation to a debt assumption from the railway company. Despite the government’s commitment to publish budgets in balance, the autumn forecast project the Belgian budget deficit to widen to 0.5% of GDP in 2007 and 2008 from the projected 0.2% deficit this year. The debt ratio, while still the third highest within the euro zone member states, is projected to remain on a firm downward path and to fall to 83.2% of GDP in 2008. Following the rating upgrade by Fitch at the beginning of the year and the positive outlook by Moody’s, spreads with other euro zone issuers are set to remain tight.

To assess the budgetary outlook, it also important to keep a close eye on the general trend in yields and the general risk appetite in the markets. Concerning the first, the outlook is a bit balanced as short-term yields are still on an upward path given the ECB rate outlook, while long-term yields are already downwardly oriented following the US slowdown. A change in trend for yields is mainly important for countries with a high debt-to-GDP ratio like Italy, Greece and Belgium, as this may have a large influence on interest expenditures and consequently budget deficits. Concerning the general risk appetite, the recent rise in ECB rates did not spoil investor’s risk appetite yet. On the contrary, on the corporate bond market spreads are still getting tighter and tighter. This may keep spreads tight between euro zone government bond yields too, despite the strong improvement in public finances in for example Germany.

CONCLUSION

Since the modification of the Stability and Growth Pact in March last year, the national budget situations do get much more attention in the European bond market. In this context, the publication of the EU Commission economic forecast provides an ideal opportunity to reassess the budgetary outlook and its possible impact on government bond spreads. This reassessment shows recent growth upturn in the euro zone also has its positive implications for public finances, as most countries under the excessive deficit procedure are likely to meet their targets. The main exception is Portugal, which will have to take additional measure to bring the budget deficit below the 3% level, but also Italy is not out of the woods yet. This general positive development was also noticed in a tightening of the spreads between euro zone government bonds. As long as yields remain relatively low and investor’s risk appetite remains high this environment of tight spreads may last, despite the underlying differences in performance.

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Published on  Fri, Nov 24 2006, 16:44 GMT

Money Supply Data Return to the Fore

Fri, Nov 10 2006, 16:36 GMT
by KBC Market Research Desk

KBC Bank

• Bank of England refers to rapid credit and money growth to justify yesterday’s rate hike
•  Two-day ECB conference on ‘the role of money’ highlights importance of monetary indicators in the ECB interest rate decision-making process
• M3 money supply growth accelerated over 2006, despite recent tightening
•  ECB’s Weber and Garganas unsatisfied with current inflation outlook
• Sustained strong eco data lessen fears for German VAT increase and US slowdown
• Consequently, we raise our official target for ECB rates from 3.50% to 3.75%  

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Published on  Fri, Nov 10 2006, 16:36 GMT

U.S: The October US payrolls in perspective

Thu, Nov 2 2006, 15:23 GMT
by KBC Market Research Desk

KBC Bank

October Payrolls should be better than September but little change in trend

• Underlying payrolls growth has probably little changed in recent months, as…..
  
• ….September’s weak figure isn’t representative for the trend….
• ….Statistics show that October consensus forecast is often close to the actual result….
• …enough for some corrective down-move in the bond market?

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Published on  Thu, Nov 2 2006, 15:23 GMT

U.S: October FOMC decision

Thu, Oct 26 2006, 06:54 GMT
by KBC Market Research Desk

KBC Bank

FED decision contains hardly any surprises

• Fed prolongs the pause in policy while keeping its tightening bias
  
• Markets react moderately positive, as fears of a more hawkish Fed prove unfounded
• Governor Lacker dissents again in favour of a rate hike, but remains a lone dissenter
• The statement contains no info about communication, the special topic
• Higher energy prices no longer upside risk for inflation, but at the same time the Fed apparently believes growth has bottomed.

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Published on  Thu, Oct 26 2006, 06:54 GMT

U.S: Preview FOMC decision

Tue, Oct 24 2006, 13:59 GMT
by KBC Market Research Desk

KBC Bank

Will the FOMC surprise the markets?

• Fed to prolong the pause in policy while keeping its tightening bias
  
  
• Economy and inflation evolve according to script; inflation expectations ease
  
  
• The market correction that erased early rate cut hopes makes the Fed’s job easier
  
  
• Governor Lacker, dissenter at the August and September FOMC meetings in favour of a rate hike, probably kept his gun loaded
  
  
• What about the communication?

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Published on  Tue, Oct 24 2006, 13:59 GMT

USA: Job report: Underlying strength

Fri, Oct 6 2006, 10:39 GMT
by KBC Market Research Desk

KBC Bank

At first glance, the job market report was weaker than expected, as it showed that the US economy created just 51K jobs in September. However, the report was actually not as weak as it appeared - it had several signs of strength among the details, and as a consequence yields edged 7-8bp higher.

 Firstly, the net revisions of +62K. The July and August figures were revised up to 123K and 188K from previously 121K and 128K, respectively. Hence, net job creation amounted to some 113K, which is quite close to expectations.

 Secondly, the unemployment rate surprisingly dropped by 0.11 percentage points to 4.58%, as the household survey showed 271K new jobs added in September.

 Finally, this report included an estimate of benchmark revisions for 2006. This revision is derived from state unemployment insurance (UI) tax records that nearly all employers are required to file. The purpose is to allow for systematic biases in the estimate of the payroll figures. BLS (Bureau of Labour Statistics) currently estimates that employment in March was 810K higher than earlier anticipated. This implies that the BLS will probably add 67.5K to payroll growth for each month from March 2005 to March 2006. Over the last 10 years, the annual benchmark revisions have averaged plus or minus 0.2 percentage points. Hence, this year’s estimate of +0.6 % is the highest in 10 years.

 The very large estimate of the benchmark revision is interesting from several points of view. Firstly, we have been wondering why employment growth has been relatively low during this recovery and why the difference between the household survey and the establishment report (non-farm payrolls) has been so large. The benchmark revision gives at least a partial explanation of this. Secondly, while the benchmark revision does not affect the unemployment rate, it adds to the argument that pressures in the labour market are rather high.

 Generally, although the latest figures do not change the picture that job growth has shifted into a lower gear following the slower economic growth in Q2 and Q3, the 3-month average payroll growth is more or less unchanged at around110K. Going forward, we still see payroll growth of around 125K as a fair level – sufficient to keep the unemployment rate in check. Further, today’s report showed the job market is still getting tighter (lower unemployment rate), which should not ease concerns on wage pressures.  

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Published on  Fri, Oct 6 2006, 10:39 GMT

September payrolls to be a non−event??

Thu, Oct 5 2006, 13:49 GMT
by KBC Market Research Desk

KBC Bank

• Payrolls growth has shifted to a slower pace of about 120 000 in recent months …..

• ….while monthly volatility has decreased sharply….

• ….convincing forecasters that more of the same is likely in September….

• …This complacency might lead to a sharp market reaction in case of a surprise

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Published on  Thu, Oct 5 2006, 13:49 GMT

German sentiment tumbles, as ECB warns interest rates could hit 4 %

Thu, Sep 21 2006, 09:41 GMT
by KBC Market Research Desk

KBC Bank

• Sentiment among German financial analysts deteriorates sharply…
  
  
• … As ECB steps up rate warnings.
  
  
• ECB ‘sources’ suggest rates could rise to 4 per cent or higher.
  
  
• Tough talk may be to distinguish ECB policy making from a ‘pause’ in the US.
  
  
• Markets still feel softer global growth and easing energy costs will prevent aggressive action.

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Published on  Thu, Sep 21 2006, 09:41 GMT

FED keeps policy unchanged, encouraged by recent developments

Thu, Sep 21 2006, 08:26 GMT
by KBC Market Research Desk

KBC Bank

• Fed prolongs the pause, keeps tightening bias and changes statement only marginally
  
  
• Even governor Lacker didn’t change tack and dissented for a second time in favour of a tightening
  
  
• Market barely reacts and discord between Fed and markets on future policy remains intact

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Published on  Thu, Sep 21 2006, 08:26 GMT

FED to prolong its pause

Tue, Sep 19 2006, 15:07 GMT
by KBC Market Research Desk

KBC Bank

• No important new developments since the previous FOMC meeting suggest a prolongation of the pause
  
  
• Inflation risks to remain the prime concern of the Fed, but Fed willing to tolerate slightly higher inflation
  
  
• No attempt will be made to “rectify” markets’ view that the pause will be followed by an easing of policy in 2007, but don’t expect the Fed to adhere to that view yet

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Published on  Tue, Sep 19 2006, 15:07 GMT

Archive

• FOMC keeps rates unchanged; No sign of imminent start of tightening cycle
  Published On Thu, Jun 26 2008, 07:54 GMT
• ECB threatens July rate rise
  Published On Fri, Jun 6 2008, 14:27 GMT
• A hot inflation summer; can the ECB sweat it out?
  Published On Tue, Jun 3 2008, 07:58 GMT
• ECB: Uncomfortable but unmoved
  Published On Fri, May 9 2008, 09:38 GMT
• Slovakia: Spring EC's forecasts increase the chances for EMU entry
  Published On Mon, Apr 28 2008, 14:37 GMT

[ View All ]

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