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Policy easing on the cards

Mon, Feb 4 2008, 10:43 GMT
by Danske Research Team

Danske Bank A/S

Macro outlook

• Weaker growth and strong headwinds are on the cards in the US for the coming three to six months. High inflation stemming from higher energy and food prices is eroding purchasing power and hurting consumption. Credit is being tightened and the house market remains in a free fall with no bottom in sight. In spite of the recent rebound in ISM, we believe the industrial cycle has turned and ISM going to edge lower. The labour market outlook has deteriorated and unemployment is on the rise. On top of all that the financial crisis is far from over, adding significantly to downside risks.

• This should lead to further deterioration of the economic outlook in the coming months. However, we are expecting a modest rebound in US growth late in 2008 as the easing of monetary and fiscal policy starts to kick in and the house market hopefully has bottomed out.

• Euroland is faring better at the moment, but the outlook for growth is also deteriorating. Consumption growth never really took off in the upturn and is now being hurt by high inflation. Growth in investments and exports also looks set to slow. The euro has strengthened and the stimulus from economic policy is much weaker than in the US. The PMI has started to decline and we expect that trend to continue. The growth outlook will be bleak in the second half of 2008.

Central banks and bond yields

• The Fed is clearly willing to err on the side of too much easing rather than the other way around. The very aggressive 75bp inter-meeting cut on 22 January, followed by 50bp at the ordinary meeting on 30 January, revealed a deeply concerned FOMC that sees significant downside risks to growth and a FOMC that is willing to act early compared to previous easing cycles.

• We foresee no major good news from the US economy in the short term and we forecast further easing in the coming months, taking the Fed funds rate to 2%. During the summer, things should start to look a little less bleak. Combined with the aggressive easing and a negative real Fed funds rate, the Fed will stop easing and remain on hold for the remaining part of 2008.

• Yields have dropped massively since mid-2007 and a lot of bad news and Fed cuts are already priced. However, two-year yields could drop further as the Fed delivers, but the 10-year yield is already at very low levels historically and compared to inflation.

• The EBC will remain on hold in the next couple of months, but as the slowdown in the economy materialises it will slowly move towards an easing of monetary policy. There is little doubt that the ECB is concerned about inflation and the inflation outlook, but this will be trumped by the deteriorating growth prospects. We are expecting the ECB to cut rates in September and December.

• Markets have moved a lot lately and at least two rate cuts from the ECB are now expected this year. The market may have gotten too far ahead of the ECB in the short term, but when the ECB delivers, yields will fall below their current levels.

Yield curves

• The US yield curve could continue to steepen in the coming months. In the long term, the US yield curve may flatten somewhat again when the Fed stops and growth prospects improve. The yield curve in Euroland will steepen when it becomes clear that the ECB will begin to cut rates. We expect this to happen on a three to six month horizon.

Country spread

• The divergence in monetary policy response will dictate the relative performance. We expect the US to outperform Euroland in the short term as the Fed is giving into the pressure for further rate cuts whereas the ECB remains hawkish due to inflation pressures. However, this picture will begin to change by mid-2008. Easing will probably be done in the US, while the ECB will be on the verge of starting.

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Published on  Mon, Feb 4 2008, 10:53 GMT