ECB policymaker edge closer to sanity, but is it too late?

Tom Tong05/Dec/2011Currency Updates

World markets reacted with a massive sigh of relief to the latest signs that European officials are starting to understand the nature and seriousness of the problem, however dimly. The ECB’s indication that it is ready to loan large amounts of money to the IMF to finance liquidity facilities for Spain and Italy represents an about face from Draghi’s sadomonetarist positioning of just a couple of weeks ago. This sea change in attitude, together with increasing signs that the US economy is decoupling from the sharp slowdown being experienced in Europe, China and many other emerging markets brought about a sharp rally in worldwide equities.

In FX markets, the Euro rallied, but much less than one may have expected given the sharp moves in risk assets, ending the week by wiping out much of its gains on Friday. It bears noting that correlations between currency pairs are near all-time highs. This means that all currencies are being driven almost exclusively by the news of European systemic risks, and country-specific factors are having very little impact.

GBP

Unfortunately, it looks like Chancellor Osborne has decided to double down on his losing bet on austerity. Even as macroeconomic and budget news make it clear that austerity is actually worsening the debt profile, by depressing activity and confidence at a crucial time and forcing the economy into a low-employment and low-output equilibrium, Osborne has decided that the solution is yet more austerity. November manufacturing PMI remained at clearly contractionary levels, 47.6.

Absent an upside surprise in next week’s services PMI, we think that the UK is already in a double dip recession. In spite of significant downgrades to both growth forecasts and the economy supply potential, the Chancellor refused to announce any stimulus measures and even contained additional tightening beyond the three-year horizon. This combination of negative data and policymakers’ stubbornness means that we will be revising downwards our Sterling forecasts soon.

EUR

The event was inevitable, though the timing much less so. The ECB is clearly in the process of doing a thorough about face. It has given signs that it intends to lend freshly printed Euros to the IMF so that the latter can create a package for Italy; a somewhat convoluted mechanism, but no less effective. Although the numbers being rumoured (a few hundreds of billion Euros) are insufficient for dealing with the problem, there is no doubt that this is a qualitative change in the ECB’s (and therefore German’s) attitude to the Euro crisis. Our concern, however, is that this may be too little, too late.

The Eurozone as a whole appears to have entered a double-dip recession, with the new orders index of the PMI manufacturing index at contractionary levels in every large European economy, and the overall number came out at a dismal 42.4 level.

Meanwhile, the news from the battered Southern economies are downright catastrophic. Spain is losing jobs at a near 100,000 per month pace – this would be the equivalent of a -800,000 payroll number in the US. Greece unemployment is up by 4% since the start of the year. Portugal is also deteriorating, and only Ireland appears to have stabilized, though this seems mostly due to migration. The impact on the ECB’s disastrous delays in implementing the needed easing on these economies, and its dogmatic insistence on further austerity in return for helping the sovereigns finance themselves remain the main clouds hanging over the global economies. As a prominent Spanish banker put it to us last week, it is not very helpful to agree to water the plants after they have died.

USD

The main bright spot in the world economy remains the US inability or unwillingness to adopt serious austerity policies, and thank God for that. The collapse of the so-called Super-committee, which was unable to agree on austerity measures is unalloyed good news. As is the developing bipartisan agreement to extend the 2% cut in social security contributions from workers, which was set to expire at the end of the year.

The high frequency indicators have clearly turned for the better. The labour market continues to improve slowly, although last week’s drop in the unemployment rate to 8.6% was driven mostly by labour force withdrawal. The ISM survey of manufacturers increased to 52.7, clearly expansionary territory, and new car sales increased to 13.6mm from 13.2mm saar the previous month.

Many uncertainties remain, most of all the sustainability of consumer spending in the face of declining labour incomes, but it is clear that the US economy is for now outperforming most other developed economies and even a number of fast-slowing emerging economies. We plan to reflect this in our forecasts by upgrading selectively our near-term predictions for the USD.

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Written by Tom Tong

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