Forex Investment and Currency Trading

Euro-Zone

Unusually blunt comments from ECB President Trichet today indicated that Euro-zone rates are likely to move higher in the near future. Market is revising its forecasts accordingly, and now sees a 25bps rate hike in July. Market expects rates to stay at 4.25% for the rest of 2008, rather than falling at the end of 2008 as it had previously anticipated. However, market forsees that a reversal of policy will be needed from early on in 2009, and looks for rates to fall by 75bps in the first half of next year.

Accelerating inflation the prime concern

Inflation, which jumped to 3.6% pa last week, is set to rise even higher over the next few months, and could well reach 4% in late-summer. Core inflation is well below headline inflation, but nevertheless is also too high, at 2.4%, and the ECB is concerned that money supply growth (mainly corporate borrowing) remains too strong. But inflation expectations remain well anchored, other measures of “core” inflation (ex-food, energy, alcohol and tobacco) are well below 2% and loan growth should slow on tightening credit conditions. Nevertheless, the ECB is unlikely to be prepared to see real interest rates (repo minus headline inflation) fall to zero unless there are serious problems developing in the economy. For now, ECB staff projections indicate a slowdown in economic growth to below trend from Q2 continuing until well into 2009 – a slowdown which the ECB’s Governing Council’s regards as necessary to prevent second round inflation effects from become entrenched.

Higher interest rates risky for already-weakening economic growth

The risks even to this weak outlook are to the downside. Economic data in the Euro-zone this week have been poor – another month of falling German orders on softening foreign demand, another month of weak retail sales, PMI manufacturing and services down. The manufacturing and services surveys still have some way further to fall before they indicate real problems (recession) in the economy. But higher rates and a strong trade-weighted euro are combining to tighten policy at a time when households and businesses are being hit by higher energy and food costs – in effect an additional tax on spending, raising the risk that growth stalls altogether.

Easing inflation pressures should allow rates to fall from 2009

By late-2008 we would expect Euro-zone inflation to be on a declining trend, though probably still above 3%. A sluggish economy, flat or falling food and energy prices (market forecasts oil prices levelling out and then declining later this year on falling demand) and base effects should help to drive inflation lower still in the first half of 2009. At this point market would expect the ECB to renew policy easing, and anticipate repo rate falling to 3.5% by Q2 2009.