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Market Recap and Outlook
The recent bond market's sell-off lost momentum last week and market rates were flat to slightly down across the main coupon curves. The only exception was the US 2-5y segment that lost ground on the back of the disappointing results of last week's auctions. Risk appetite indicators continued to improve, albeit at a slower pace than in the recent past. However, equities failed to register solid directional movements as most of the positive surprises coming from the Q2 earning season had already been absorbed.
The economic scenario has not changed much over the week. There has been further evidence that global economic activity has bottomed out in H1, with survey indicators pointing higher and preliminary GDP figures showing a slower pace of decline in Q2. The Fed's Beige Book didn't show any major surprise: all Fed Districts suggested that “Economic activity continued to be weak, but most Districts indicated that the pace of decline has moderated, albeit at a low level".
Inflation data surprised on the downside, with EMU HICP down to a new record low. However, markets don't seem to be much worried about deflation risks at the current stage.
Some “good” news came from the ECB Bank Lending survey and – despite the limited market impact – the recent results might set the tone of this week's ECB Governing Council meeting.
In details, the Q2 lending survey showed that while banks have continued to tighten lending standards, the degree of tightening standards has fallen substantially. In particular, EMU enterprises have registered a large improvement in July, with the diffusion balance recording the change in credit standards down to 21% in July from +43% in April. Banks also expect further improvement in Q3, with the diffusion index down to 12% from 28% in Q2. On the demand side of credit, the improvement was less marked. However, there are tentative signs that the situation is moving in the right direction.
In our view, the ECB Governing Council will consider the results of the survey as very good news as it gives support to the idea that the ECB's "enhanced credit support" strategy is currently helping the monetary transmission channel and reduce the risks that a “blocked” credit mkt could limit the potential for a solid economic rebound in the medium term. That said, the credit market is not the only factor that the ECB will be looking at this week. Risks for both economic activity and inflation will remain the main focus for policymakers. As for the recent development of economic indicators, the ECB will welcome the news that the worst of the ongoing recession seems to be behind us. Nevertheless, the ECB will continue to highlight that there are still many downside risks looming. As for inflation, the new record decline in EMU HICP will be a surprise for the ECB. However, we still expect Trichet to play down medium-term deflation risks as the ECB is willing to avoid wide-spread panic.
All in all, we expect the tone of this week's ECB press conference to be relatively neutral. We rule out that the GC is ready to outline the details of a possible exit strategy although some ECB members suggested that a plan is already on the paper. In our view, the ECB will maintain its “conservative” tone, suggesting that it is ready to act any time soon. However, with EMU inflation falling to record lows and survey evidence suggesting limited inflationary pressures in the medium term, there is no reason for policymakers to suggest that some tightening is in the cards any time soon.
The MPC meeting will be another crucial market event this week. Whilst Bank Rates are widely expected to remain unchanged at 0.5%, the possible extension of the current QE programme is far from being an easy call. Market consensus is currently equally split, with the latest Reuters BoE survey showing 31 economists anticipating an additional GBP25 to current QE and 32 respondents voting for the end of the asset purchase plan.
Last week, the Bank of England announced that it is extending its commercial paper purchase operations to cover secured paper, either via issuing bills or by the creation of new central bank money. In our view, this is not a sign that the BoE will also extend its QE programme as the two measures can go in separate directions.
On balance, the MPC might still decide to increase the current QE plan by an additional GBP 25bn next week as recent economic data have been mixed, with encouraging signs on the housing activity side but a bleak picture for GDP growth in Q2. Should instead the MPC decide to keep the QE plan on hold, this week's accompanying statement will have to leave all options open for the near future as risks for growth are heavily skewed to the downside and we rule out that the August Inflation Report will show a considerable upward revision for economic activity in the next two year.
As for the US, market attention will be focused on the July employment report next Friday. Our preliminary forecast is for NFP to fall by 390k in July from –467k in June. Recent indicators on the development of the labour mkt have been mixed.
Weekly jobless claims point to a considerable improvement in July but we have to bear in mind that recent data have been distorted by seasonal adjustment factors. On the other hand, survey evidence shows limited improvement in the labour mkt, with industrialists showing no marked improvement and households suggesting further deterioration in July.
Today's market movers
Today's economic calendar kicks off with the release of German retail sales at 7 BST and a string of business confidence indicators will follow later in the morning and in the early afternoon. Business confidence will come in the form of July manufacturing PMIs in the eurozone and UK at 9 and 9:30 BST respectively whilst in the US the correspondent manufacturing ISM is scheduled at 15 BST.
As for German retail sales, we anticipate a modest 0.6% m/m increase in June after the downward revised –1.3% in May. German retail sales data are very volatile (and they are often heavily revised). As such, it is difficult to infer a clear trend of household spending development from monthly data. Our forecast is mainly based on survey evidence that – in the past couple of months – seems to have edged higher. The Gfk consumer confidence index – for example – posted a large upswing in June and July and the spending intentions sub-component increased by 2 full points in June. The European Commission consumer confidence index has also posted a solid increase in June, boosted by expectations of a better economic outlook and increasing willingness to embark on major purchases. Everything seems to point to a modest improvement in consumer spending although the picture is still clouded by weak labour mkt conditions and tight credit standards.
As for business confidence, we don't expect much of a surprise from EMU data. Preliminary July figures have already suggested a marked increase in headline figures in all the major EMU countries. The EMU manufacturing index rose to 46 in July from 42.6 in June, reaching its highest level since last November. There is increasing evidence that EMU economic activity has bottomed out in H1. However, the indicator still points to a small contraction of economic activity in Q3. As such, we would be very cautious before calling the end of the ongoing recession.
As for the UK manufacturing PMI, we expect another slight improvement in July. However, the pace of increase is likely to slow further compared with the previous months. In July, we expected the overall index to rise by 0.6 points after it rose 5 points back in March, around 3.5 in April, 2.5 in May and 1.5 in June. Note that – despite the recent improvement in business confidence – manufacturing activity continued to contract in Q2, as suggested by the preliminary Q2 GDP data. This is a clear signal that the UK economy is not out of the woods yet and signs of positive growth are expected only around the turn of the year.
In the US, we project the manufacturing ISM index to rise to 46 in July from 44.8 in June. This would be the seventh consecutive monthly increase in the business confidence index and further evidence that the worst of the current recession is behind us. Nevertheless, we remain cautious on the near-term development of the US economy. Indeed, last week's preliminary Q2 GDP data were not reassuring as all the main components showed wide-spread weakness. It doesn't look like there is a strong base for a self-sustaining recovery in the US near term and – in our view – risks of disappointment are still very high.
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