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Soaring oil prices and credit crisis weigh on equity markets and dollar

Mon, Jun 30 2008, 11:27 GMT
by BHF-Bank Economics Department

BHF-Bank

Highlights

• Inflation rates in the eurozone set to hit record highs, growth outlook gloomier

Growth concerns put dollar under pressure

During the course of the week, the dollar lost ground across the board again. Towards the end of the week, EUR-USD was around 1.5750. The US currency did not fall all that sharply compared to the previous week, but it is now nearing the “upper limit” of the trading range over the last few months again. USD-JPY remained relatively firm, dropping to under 107. In contrast, EUR-JPY gained more ground: during the course of the week, the European currency rose to 169.46, – a new record high against the yen.

The fresh bout of depreciation was triggered by the Open Market Committee’s statement on Thursday. According to the Fed’s latest risk assessment, the balance of risks has shifted towards inflation risks, but only slightly. Furthermore, in its description of the risks, the Committee was non-committal: uncertainty about the inflation outlook had increased, but inflation was expected to moderate later this year. Consequently, the statement contained no indication of an imminent interest rate rise, apart perhaps from one single vote: Dallas Fed president Richard Fisher was in favour of raising the fed funds rate.

The Fed’s relatively dovish stance is, however, in line with market participants’ mood. Up until recently, soaring energy and commodity prices and accelerating inflation in their wake had been regarded predominantly as a challenge for monetary policy. Thus the increase in oil prices went hand in hand with interest rates hikes. But the higher the oil price climbs, the more the growth risks come to the fore.

The price shock caused by rising energy and commodity prices together with the financial shock emanating from the credit crisis are having a dangerous contractive impact. On the one hand, there are stricken banks, whose scope to act is limited due to asset writedowns and functional disruptions in important market sectors. The banks are passing the buck to their customers by tightening financing requirements and credit conditions for consumers and companies alike. On the other hand, there are companies and households deep in debt; because of the soaring energy and commodity prices, they are forced to cut back their costs and limit their spending.

Towards the end of the week, the oil price (WTI front contract) rose to over $141 per barrel. Several factors were responsible for this: production shortfalls in Nigeria due to strikes, the OPEC president predicting that the oil price would rise to $170/b in summer, and Libya threatening to reduce output. This price surge and a spate of negative news from the financial sector probably contributed to the slump in equity markets – during the course of the week, the Dow Jones fell by about 5%. Despite the fact that the oil price is still rising, interest rate levels and rate hike expectations have been scaled back noticeably – not just in the US, where the Fed is in “wait and see” mode, but also in the eurozone, where the central bank has already signalled that it will raise interest rates to 4.25% next week.

Inflation in the eurozone appears to have accelerated more sharply than expected in June: according to the national data available so far, inflation could have increased to at least 3.9% year on year. And if the oil price of over $140/b does not correct soon, inflation could even rise significantly over 4% in the next few months. This would be considerably higher than the ECB projection for 2008 (3.2 to 3.6%).

Partly due to rising energy and commodity prices, business and consumer polls are signalling that the economy is slowing down noticeably. The ifo institute indicates that the business climate has deteriorated significantly in June, by 2.2 points to 101.3. The drop in the manufacturing industry was particularly striking. Moreover, according to GfK, the consumer climate plummeted from 4.7 to 3.9. In the eurozone as a whole, the climate deteriorated even more markedly: the EU Commission’s indicator of economic sentiment fell by 2.7 points to 94.9, and is now nearing levels last seen in the period from 2001 to 2003.

It is practically a foregone conclusion that interest rates will be raised at the ECB Council meeting next Thursday. In view of the recent developments, the ECB will probably emphasize the inflation risks after the decision too. The hawkish tone is likely to be retained. However, the latest climate and confidence indicators provide enough ammunition for presenting the growth outlook in a slightly more critical light. Credit growth to non-financial corporations was also weaker in May for the first time. The ECB will therefore probably refrain from making any firm interest rate policy commitments.

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Published on  Mon, Jun 30 2008, 11:31 GMT