EUR likely to fall as rate cuts become apparent
08/01/09 15:49
Ref:UBS
Investors looking for an extensive early year rally were brought down to earth yesterday as signs of a deepening recession became apparent and investors pared risk positions. . Early-year rallies in risk, especially during recession years as markets attempt to price in an early recovery, are often hazardous and a swift realisation of circumstances is consistent with the view that the market will remain structurally risk-averse in the coming quarters. This risk aversion will fuel USD and JPY strength.
Investors looking for an extensive early year rally were brought down to earth yesterday as signs of a deepening recession became apparent and investors pared risk positions. . Early-year rallies in risk, especially during recession years as markets attempt to price in an early recovery, are often hazardous and a swift realisation of circumstances is consistent with the view that the market will remain structurally risk-averse in the coming quarters. This risk aversion will fuel USD and JPY strength.
This morning rockets were fired into northern Israel from Lebanon and Israeli defence forces have already retaliated, making an escalation of conflict possible and this will have positive implications for oil and may hurt the dollar in the short term. These factors point to ongoing support for the dollar longer term as a safe haven and the greenback held its ground. Aside from the BoE interest rate decision today (see below), the market's main focus will be on US President-elect Obama's economic policy speech, where he is expected to unveil a much-anticipated fiscal stimulus package. The size of the plan is expected to be around $800bln, divided between spending and tax cuts, but he may also intend to manage expectations as the fiscal burden on the US is rising by the day. The Congressional Budget Office yesterday revised its estimates on this year's budget deficit to US$1.2 tln or 8.3% of GDP, well above the US$ 438 bln in their September estimates as the government was forced to ratchet up spending to help the financial sector. Nevertheless the CBO endorsed the fiscal stimulus plans and warned economic contraction would be greater without such spending. We believe financing new spending will be an increasing source of concern for all governments this year; yesterday's failed Bund auction is already a warning signal for limited investor appetite in government debt. So far US debt has not been affected but we expect market sensitivity to these auctions will gradually rise in the coming months. For now dollar demand remains firm. As the BoE statement showed, many economies clearly see a need for further easing in conditions and with the Fed well ahead of the curve, pressure on the dollar from yields will be minimal. Ahead today, initial jobless claims at 1330 GMT. President-elect Obama's speech is scheduled for 16:00 GMT. Look short the EUR in the coming weeks.
As expected, the BoE cut its policy rate by 50bp to 1.5%. The rate is now the lowest on record which, for an institution founded in 1694, illustrates the historic nature of the global economic crisis. The move seems to be designed to support the UK economy while not being too large to put undue pressure on sterling. UBS economists see further cuts ahead, expecting the rate to fall to 0.5 % in the coming months, as the health of the UK economy deteriorates further and inflationary pressures continue to decline. The BoE statement noted that "there remained a significant risk of undershooting the 2% CPI inflation target in the medium term at the existing level of Bank Rate", and note that this is consistent with further easing. The BoE appears to be comfortable with developments in sterling at this stage, though there was a warning that the cost of imports may rise. However, downside risks to prices are of a greater concern and the momentum is still strong as CPI continues to decline. With conventional monetary firepower now close to depletion, attention is shifting towards the question of whether the BoE will be forced to follow in the footsteps of the Fed and engage in alternative forms of monetary easing. The MPC meeting minutes are due to be released on 21st January.
Another disappointing set of economic data emerged from Europe this morning. Coming in at -0.2% q/q, final Q3 GDP growth was negative for a second consecutive quarter, confirming the onset of recession across the eurozone. There was bad news too on the unemployment front with the jobless rate rising, as expected, to 7.8% (prior 7.7%). Confidence indicators plunged across the board with consumer, economic, industrial and services readings all falling well below both last month's levels and consensus expectations. The new data is likely to lead to further calls on the ECB to cut aggressively at next week's rate-setting meeting. With CPI moving below 2% and a reversal in recent ECB member commentary, our economists are now looking for a 50bp cut and still expect the ECB to ease to 1% in the second quarter. We see a weak euro ahead and put out a trade recommendation to go short EURUSD with a target of 1.2850. Elsewhere, Swiss data told a similarly depressing economic story, with the December jobless rate rising to 2.8%, in line with market expectations. Swiss CPI surprised the market by coming in sharply lower than expected at a mere 0.7% y/y (cons. 0.9%, prior. 1.5%), increasing the risk of deflation in the months ahead.