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Monday, January 21, 2008

Getting Choppy, and the Eurozone Gets the Backwash

Well there I was, quietly working away on a series of studious posts about the German, Italian and Japanese labour markets, trying to justify - following an exchange in comments - why I think creating a lot of additional employment among the over 55s won't offset the shortage of bright young educated people that ageing economies and societies will increasingly encounter, when suddenly the global storm seemed to take a swirl for the worse. So I can't just let sit back and let all this pass without even expressing a word:

The FTSE 100 on Monday suffered its biggest one-day fall since the terrorist attacks on the World Trade Centre more than six years ago as fears about the prospects for the global economy took hold.

In a tumultuous session, the index fell as much as 5.6 per cent as dealers capitulated following sharp falls on Asian markets overnight.

This is just short of the 5.7 per cent fall at the close on September 11 2001. "The acrid smell of fears hangs over the City. I've never seen fear like this," said David Buik at Cantor Index.

It's hard to say at this point how far or how deep this will now go, or where it will end, so I guess it's better to take things one day at a time.

But meanwhile it is perhaps worth noting how things are really heating up now in the eurozone interest rate debate, and in the euro-dollar currency markets. In the middle of last week Luxembourg's Central Bank Governor Yves Mersch set the ball rolling when he warned of "downside risks" to growth in the eurozone, sending in the process the yield on the 10-year German benchmark bond below 4 percent for the first time in seven weeks. Then ECB official Axel Weber said in Cyprus that euro-region inflation would slow toward the bank's 2 percent ceiling later this year, despite the fact that on average eurozone prices grew at an annual 3.1 percent rate in December. This is more or less code language for saying that growth is expected to slow, and that interest rates will thus need to come down. This has some significance since Weber has - up to now - been more or less in the "hawks" camp at the ECB. His expression of opinion was then followed by Portugal's Finance Minister Fernando Teixeira dos Santos in a statement where he indicated that he shared "concerns that the slowdown in European economies could be somewhat stronger than we expected a few months ago" and then of course we had the downward revision in the 2008 Italian forecast from the Bank of Italy, which I have already commented on.

So it seems the economic slowdown is finally being recognised as what it is, a far more general issue than a simple sub-Prime problem in the United States.

The process accelerated further this morning, with the euro falling to a five-month low against the yen after European Central Bank council member Nout Wellink admitted that economic growth may slow more than policy makers had expected. Wellink suggested that eurozone growth will be closer to 1.5 percent than 2.5 percent in the coming year. All of this is causing a good deal of uncertainty in the currency markets with the euro falling 1.8 percent against the dollar in the past five days to a three-week low of $1.4510. This is, of course, still a very high value, but what we need to be aware of is that what causes most damage, economically speaking, are violent swings, and at this point in time there is no guarantee that we may not be in for some of those.

What's interesting about the above linked Bloomberg article is the way these statements are being read. That is, higher than desireable inflation is now no longer the plus it was (we have been living for some months now on top of a discourse where inflation was virtually being seen as a positive by currency traders since it meant that interest rates, and hence yield differentials, would rise). This discourse seems to be coming to a rather abrupt end. We could perhaps notice some first indication in Romania in the middle of last week, where the focus moved from the inflation there driving up yield, to the fact that the central bank effectively needs to maintain rates up to stop capital outflows. Hungary is a very similar case (and here). This is also being reflected in a weakening in the so called carry trade and steady upward pressure on both the Swiss Franc and the Japanese Yen.

So the fact that the ECB may be tardy in dropping rates is no longer being read as a euro positive. Market participants seem to be reaching out further into the future, and are thinking more about the future path of relative currency values. Since the ECB can't cut, economic growth will tank more than it would do otherwise, and then the ECB will cut vigourously, so at that point the euro will fall. This seems to be the reasoning, of course, by having the thought these participants simply bring forward the moment when the decline starts, and as a result it starts to fall now. I think this is a sea change.

Of course, if, as the Bloomberg article suggests, the euro is about to follow the dollar into "swoon", we might like to ask ourselves which currencies are in fact going to rise, since given that currency values are relative, they can't all fall at once. My feeling is that the US administration will resist any strong upward correction in the dollar, since they have their own issues to think about - and not least among them the trade deficit - which mean that weaknesses in domestic consumption need to be compensated for by exports, and as a result dollar competitiveness becomes important. In this context Claus Vistesens latest note this morning is, as ever, interesting.

Update Tuesday

Well today seems to be an even rougher one in the global stock markets, and now the EU finance ministers have, more or less, made it official. The eurozone is slowing faster than expected.

European finance ministers said a global stock-market slump and an economic slowdown in the U.S. threaten to slow growth in Europe more than forecast.

``The economic situation and financial markets are highly volatile and uncertain, a good deal more uncertain than usual,'' Luxembourg Finance Minister Jean-Claude Juncker said yesterday in Brussels after presiding over a meeting of counterparts from the euro region. ``If there is a real slowdown in the U.S., obviously that would be felt in the euro zone.''

A global stock-market rout continued as Asian equities tumbled today by the most since September 2001. The slump has wiped more than $5 trillion from share markets around the world this year on concern global growth is faltering. Juncker said forecasts for European expansion will need to be revised down and that an economic contraction in the U.S. can't be ruled out.

Well, maybe I should qualify the above in a number of ways. First off, I think it is important to stress that the eurozone is slowing more than some expected. I think Claus Vistesen and I have been arguing quite consistently since the credit crunch began on 9th August 2007 that all of this was inexorably coming (see here, and here, and here, for example), and secondly it is ever so important to grasp that what is happening is much more extensive than the discourse Junkers advances seems to recognise. There has been a change in the credit conditions, and this change is now being felt, but what it is serving to do is reveal underlying weaknesses in some key eurozone economies. Weaknesses which would exist regardless of whether or not there had been a "sub-prime bust" in the United States. Each case is different, but Spain, Italy and Germany all now seem set to go into the grinding mill, strangely it would seem to be France - as I argue here, and Claus argues here, which may withstand all this the best.

For what it is worth I think we should all now have our eyes on Eastern Europe (and here), and on the German link in with the region via export dependence. Beyond Europe we should now watch China carefully, and if the slowdown there is more rapid than expected then all eyes should shift to Japan, since with sales to US and Europe now weakening, if the Chinese shoe drops, then the Japanese economy is going to be in all sorts of trouble.

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