Highlights

  • European yield curve on the brink of becoming inverted
  • France dampens growth euphoria in the eurozone
  • ECB admits that relation between money supply and inflation is unstable

Dollar loses ground again

Due to the lack of important indicators this week, EUR-USD hovered between 1.27 and 1.28. It was not until the People’s Bank of China announced again its intention of diversifying its dollar-denominated foreign currency reserves more widely that EUR-USD rose to 1.29. Thus the dollar’s strength, which had been sparked by US labour market data at the end of last week, faded again. But the greenback managed to hold its ground better against the yen. This could have been partly because the weak indicators have led forex market players to expect a negative growth rate for Japanese GDP in Q3 (due next week).

Japanese central bank governor Toshihiki Fukui will therefore have to postpone the gradual raising of interest rates which he had announced in view of the impending inflation risks. At the end of the week, USD-JPY was around 117.50. Thin trading in the major currencies at the beginning of the week boosted several minor currencies.

Thus the Czech koruna, the Polish zloty and many other emerging nations’ currencies reached the highest levels for several months. On the other hand, towards the end of the week, the pound Sterling dropped again versus the euro. Apparently some market players had not entirely ruled out a 50bp hike, and were disappointed that the Bank of England only raised rates by 25bp.

However, the most striking phenomenon this week was the fact that the European yield curve flattened even further. The spread between 2 and 10-year bonds disappeared completely at times. Thus it has fallen by about 15 basis points during the last two weeks.

Two very different developments are responsible for this. The US bond market had recovered quite quickly from the substantial losses incurred after Friday’s surprisingly robust US labour market data. The steeply inverted US yield curve indicates that market participants are expecting the economic slowdown in America to continue. The 10-year Bund yield has followed this development to a large extent. On the other hand, interest rates at the short end have continued to rise significantly as a result of stereotype hawkish statements of ECB council members in preparation for a rate rise in December. Meanwhile, market players are no longer entirely ruling out a rate hike to 4 per cent in the first half of next year.

But the inverted curve for money market forward rates further ahead also shows us that markets expect the ECB to overshoot in its eagerness to raise interest rates: forward rates are falling slightly in the second half of next year.

One of the reasons why market participants are expecting the ECB to step up tightening in the first half of next year is that, because the economic data in the eurozone are so strong at present, they do not think that the German VAT increase will have much impact on the economy.

In our view however, the dampening effect of the VAT increase and the other fiscal burdens are being significantly underestimated at the moment: because of Germany, the EU Commission is only expecting the average growth rate in the eurozone to be 0.25% in Q1. The French GDP figures also give reason for caution: as a result of stagnation in Q3, the eurozone growth rate is likely to be significantly lower than in the second quarter: 0.5% or even slightly less. The data is due to be released on Monday. Another interesting feature this week was that the ECB admitted for the first time that the relation between money supply and inflation is not always clear. If money demand has in fact increased sustainably in the euro area, high money supply growth does not necessarily lead to high inflation.

These findings could become significant because the ECB will revise its inflation projections for the coming year significantly downwards in December. Further interest rate rises, which markets have already priced in, would then have to be justified by a stronger economy and high money supply growth. We still think that the ECB will switch to neutral after the rate hike in December and thus introduce a lengthy interest rate hike pause.

Next week, the focus is likely to be on US inflation data and Q3 growth rates in the eurozone. We are expecting headline inflation rates for producer and consumer prices to sink again markedly. However, the core rate ex food and energy will probably remain unchanged.