GERMAN DATA PUTS EURO ON THE BACK FOOT
THIS week brings policy meetings from the Bank of England, the Reserve Bank of Australia, the Bank of Canada and the European Central Bank. While the market is not expecting a change in policy from any of these central banks, the rhetoric will be closely monitored for any signs of cautious optimism. The ECB’s policy meeting may be the most interesting, because it has promised to flesh out its plan to buy covered bonds. Analysts will also be interested to see how policy makers in the Eurozone have digested recent data.
In the first quarter the German economy contracted by a terrible 6.9 per cent year-on-year and while more recent numbers are not quite so horrible, another contraction of activity seems likely in the second quarter. Yet, last week’s May labour data showed that German unemployment increased by a very modest 1,000, well below the 64,000 that the market had expected. The data initially brought some relief but there has been no tangible change in the view that the Europe’s most sizeable economy faces hard times.
There is no getting away from the fact that unemployment is a highly politically charged topic during a recession. Governments in many countries have in the past used youth training schemes and other initiatives to reduce the numbers of of jobless people counted as unemployed, and it seems this happened in Germany. This month a new law reportedly knocked 20,000 from the jobless count and onto the training scheme count. Government subsidies on social insurance payments are being offered to companies to keep idle workers employed and sceptical analysts are judging these to be having a significant impact on German labour statistics.
In view of the 9.7 per cent year-on-year decline in German exports in the first quarter, the horrible 20.4 per cent year-on-year decline in industrial production in March and the fall in the “current assessment” component of the May IFO survey, there seems little room for unemployment in Germany to do anything but worsen in the months ahead. Germany’s economy is heavily dependent on its export sector and with consumption slumping in the rest of the world, growth will be particularly hard hit. The German government is forecasting a contraction of 6 per cent in 2009. The Economist Intelligence Unit (EIU) is a little kinder with its forecast for 2009 GDP at 5.2 per cent. To put this in perspective, the EIU forecasts a 2009 contraction for the US at a much more moderate 2.9 per cent. Faced with a huge downturn, it promises to be a slow grind back to trend growth for the German economy and this will test the integrity of the structural reforms that the government put into place over the past decade. Theoretically, labour market reform should increase labour market flexibility, which should translate into a relatively solid pace of recovery in employment once recessionary pressures ebb.
The mandate of the ECB is focused only on inflation; it has no direct responsibility to put people back to work. However, a country suffering increasing unemployment is also likely to be suffering from disinflation: last week the German May Consumer Price Index registered 0.1 per cent month-on-month. Falls in energy prices have placed a temporary negative pressure on the CPI index but there is some suspicion that the weakness of the economy may place a more sustained downward pressure on CPI over the coming months. Crucially, if the ECB also holds these suspicions, then the chances of policy being eased further increase. Thus, while steady ECB policy is expected on 4 June, there is a strong possibility that concerns over economic weakness could cause the ECB to extend its dovish tone and this would keep the euro on the back foot.
Arguably, the recent uptrend in the euro-dollar has already begun to flounder. Certainly, the fact that the pair has already rallied around 14 per cent from its October 2008 low may make further near-term upside difficult. The market is still unsure about whether activity in euro-dollar last week was a consolidative phase within a euro bull run or whether the dollar is positioning itself for a recovery.
While the dollar has already been undermined by the Fed’s heavy use of quantitative easing, in the longer-term it could benefit against the euro if the US growth story proves to be much stronger than that in the Eurozone. While the euro bulls and bears fight it out over the summer it is likely to be a choppy period for euro-dollar. And the possibility that the Eurozone could still throw us a host of very poor economic news suggests that a dollar recovery remains a firm possibility.