Forex Investment and Currency Trading

Incoming data suggest that the Eurozone is currently divided between a resilient North, with Germany and to a lesser extent France still enjoying decent cyclical conditions, and a struggling South, with Italy and Spain drifting into sub-potential growth rates. However, on balance, economic activity in the Eurozone remains sufficiently strong to help the hawks at the ECB to resist calls for rate cuts, at a moment when inflation continues to accelerate.  The probability is raised that the ECB may not cut at all this summer from 35% to 40%.

The hawks within the ECB Governing Council have spent a rewarding week: their argument against cutting rates has been strengthened by incoming data. On the real economy side, business surveys convey a very reassuring message on the health of the two biggest countries of the monetary union. There is no tangible evidence of any major transmission of
slower US demand on economic activity in the Eurozone, and the resilience to the stronger euro is impressive. On the inflation side, consumer prices accelerated further in Germany in March which warrants the ECB’s tough talking against the risks of an inflationary spiral.

Last week’s data on the real economy brought a half surprise and a big surprise. The half surprise was the continuing improvement in the Ifo business climate. The German industry still seems impervious to the euro appreciation and slower US demand. The extent of the resilience is impressive, but can be explained by the favourable positioning of the
German industry on top-range products and fast-rising markets such as Eastern Europe and emerging Asia. Conversely, the improvement in manufacturing business confidence in March in France was a complete surprise.

In February, the rise in the Ifo business climate was chiefly explained by an improvement in confidence in the retail sector. In March, manufacturing took the lead, the index rising from 16.3 to 17.9. This is significantly below the recent peak of 28.5 in May 2007, but sill above the highs reached during the previous cycle (17.2 in May 2000). This is a remarkable achievement given the appreciation in the currency and the slowdown in US demand. On the domestic side, retail confidence dipped marginally from +1.3 in February to -0.9 in March, but this figure is still consistent with a significant rebound from the trough at -17.4 reached in January 2008. This suggests that the German consumers are
gradually coming to terms with the inflationary shock triggered by the VAT hike last year and the rise in energy and food prices.

As a note of caution, the strong Ifo is certainly good news, but its predictive power for GDP growth should not be overstated. A simple regression of qoq GDP growth on headline Ifo would yield a correlation coefficient of 0.49 over the last 10 years, and a model based on the Ifo would have significantly overestimated GDP growth in 2007.

The INSEE business survey in France pertains to the industrial sector only. Its headline business climate indicator rose from 107 in February to 109 in March. The crucial “own company” production outlook declined marginally from 15 to 14, but remains above the 10 year average (11). A striking feature of the release was the improvement in foreign order
books, from +1 to +5. This subcomponent is quite volatile, but the good reading for March is a tentative sign that the French industry is coping with the strong euro. However, the survey does not distinguish intra from extra Eurozone foreign orders. The resilience in the French industry could be a by-product of the robustness in Germany, given the strong trade links between the two countries.

This stream of optimism did not manage to cross the Alps. The Italian ISAE survey in manufacturing fell 0.6 pt mom to 89.0 in March, reaching the lowest level since October 2005. The forward-looking order books subcomponent fell sharply by 3 pts down to -16.

News from Spain continue to point to more softness in the economy. Retail sales fell by 2.7% yoy in February, down from -2.5% in January and -2.2% in December. It seems that consumers are reacting sharply to the steep deterioration in employment (+200k over one year), which is now not only caused by layoffs in the correcting construction sector, but is
also fuelled by massive job cuts in the services.

Still, on balance incoming data play into the hands of the hawks at the ECB: in the Eurozone, whereas the inflationary spike is tangible, any slowdown in economic activity remains to be clearly reflected in the data. This does not constitute a favourable configuration for cutting rates.

According to the preliminary estimate, German inflation accelerated from 2.9% yoy in February to 3.2% in March, significantly above the market expectation for 3.0%. The fact that Easter bank holidays came earlier than usual this year may have pushed some prices up (catering, package holidays, transportation), but there is now a serious risk that Eurozone inflation rises to 3.5% in March, from 3.3% in February.

Trichet at the European parliament last week was even more hawkish than in his monthly press conference in Frankfurt on 6 March. He clearly wanted to dot all the i’s. By stating quite bluntly that cutting rates in response to the financial market turmoil would have created ” moral hazard and higher inflation”, he stuck to the current ECB’s willingness to distinguish as clearly as possible the rescue of the money market, through massive liquidity injections, and monetary policy itself, which is governed by “a single needle on the compass”, i.e. price stability. To drive the point home, Trichet repeated that the current monetary stance was contributing to contain inflationary pressure, implying that no rate cut was on the cards.

Furthermore, the use of the word “vigilance”, towards the end of the statement, followed by a re-affirmation of the need to continue to firmly anchor medium to long term inflation expectations, was startling, since the “v” word was used repeatedly by the ECB during the tightening phase which ended in the summer of 2007. However, the “v” word was placed in a paragraph on financial stability and seemed to refer more to possible deteriorations in banks’ balance sheets. As such, the use of that word should not be over-interpreted, but Trichet’s tone reflected a firm confidence in the path chosen by the ECB: in the eyes, of the Governing council, cutting rates at the current juncture would be a mistake.

ECB will have to review its current stance. Bad news from the US is accumulating, the additional appreciation of the euro will be increasingly painful and countries such as Italy and Spain will probably be a significant drag on the Eurozone’s GDP growth. However, it seems that it is going to take longer than market previously anticipated before enough soft data accumulate on business activity in the Eurozone to abate the ECB’s fears of second round effects on inflation. The call for the first rate cut by the ECB is pushed back to July, from June, and there is the probability that the ECB does not cut at all this summer from 35% to 40%, on account of the resilient inflation, fed by an unexpected absence of reaction of the commodity markets to the deterioration in prospects for global demand.