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FX Briefing

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Pound recovers after December sell−out

Mon, Jan 12 2009, 08:58 GMT
by BHF-Bank Economics Department

BHF-Bank

Highlight

• US fiscal package only gives a temporary boost

• EMU economic data indicate record decrease in GDP

Icy economic climate

In thin trading in the last two weeks of 2008, EUR-USD was relatively unspectacular at around 1.40. However, in the first full trading week of the new year, the market started gathering steam again: the pound was this week’s winner; it rose significantly against the dollar and the euro.
GBP-USD gained over 5% to 1.53, EUR-GBP fell more than 6% to about 0.90. The sharp movement appears to have been due to sizeable short positions in pounds, which had been built up during December, being closed prior to the BoE’s interest rate decision. Some economic indicators, such as retail sales, had not been quite as bad as expected, which is also likely to have played a part. Furthermore, it was uncertain how big the central bank’s rate cut would be. And in fact the bank rate was “only” cut by 50 basis points to 1.50%.

There was some movement in EUR-USD too. By Tuesday afternoon, the euro had dropped by around 6 cents to just over 1.33. The momentum in the dollar’s favour was triggered by equity markets, where risk appetite appeared to have increased somewhat at the start of the new year.
First and foremost, the new US economic stimulus package gave rise to some premature optimism. Barack Obama, who will be inaugurated as US president on 20 January, and the new Congress, which now has a Democratic majority, are working full steam ahead on a massive stimulus package. It is reported that this package, which is to be passed by mid-February, will be in the region of $775bn, i.e. about 5% of GDP, and run for two years. Compared to that, the German government’s new €50bn stimulus plan looks relatively modest.

In the second half of the week, however, the mood became more subdued again. Equity markets fell back, and the dollar weakened. Towards the end of the week, EUR-USD was around 1.37. Markets were brought back down to earth by the economic data coming in: the ADP indicator showed a record loss in December of almost 700,000 jobs in the US private sector. In the eurozone, the economic data published were disastrous: in November, German exports slumped by over 10% month-on-month, and industrial new orders in the manufacturing sector plunged by 6% as in October. German industrial production fell by 3.1% in November. If production remains unchanged in December – and this is by no means certain – there would be a quarter-onquarter decline of 5.0% in Q4. in France, things look even worse: there, the quarter-on-quarter decline in Q4 would be 5.8%.

Thus the worst fears for the fourth quarter seem to be coming true. The current figures indicate that there could be a quarter-on-quarter drop of up to 2% in German GDP in Q4. Things do not look much better for the eurozone as a whole either. What is particularly scary, however, is that the trend throughout the whole of Europe is still pointing downwards. The EU Commission’s survey results, for instance, deteriorated sharply again in December. The economic sentiment indicator plummeted from 74.9 to 67.1. That is the lowest level by far since 1985 when these figures started being recorded.

In December, the ECB governing council had emphasized that the interest rate decision in January was “open”. After the meeting, some council members had even signalled that they would prefer to leave interest rates unchanged in January. However, the latest data are so bad, that we now think a 50 bp interest rate cut is the most likely option next Thursday. Even Bundesbank president Axel Weber, one of the hawks, admitted in a recent speech that some of the downside risks listed in the December projections of the Bundesbank and the Eurosystem, had already become evident, and that the last quarter of 2008 was likely to turn out worse than previously expected. The economy was not likely to pick up again until 2010.

It is still not clear, however, what course of action the ECB will take on Thursday. If interest rates are cut, the ECB will probably try to diminish further interest rate cut expectations, as it did in December. If, on the other hand, the central bank leaves interest rates unchanged, it will at least have to acknowledge additional growth risks and thus indicate its willingness to cut rates. There will therefore be no clear signals for the markets. But, regardless of how the ECB acts on Thursday, economic developments will in the end force monetary policy to reduce interest rates further. The interest rate cycle in the eurozone still has a long way to go before reaching its trough.

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Published on  Mon, Jan 12 2009, 09:02 GMT