Fed to the rescue Econoday International Perspective - Friday, August 17, 2007 By Anne D. Picker, Chief Economist

Global Markets

Global financial market turmoil continued last week with many central banks (except the Bank of England) providing funds to maintain liquidity. The climax was early Friday morning in the U.S. session when the Federal Reserve cut its discount rate by 50 basis points to 5.75 percent. It left its policy fed funds rate unchanged at 5.25 percent. The move sent equities soaring in Europe and later in North America while the U.S. dollar declined. This was the most turbulent week for markets since March 2003 at the height of the Iraq War according to the Vix index of market volatility — it rose to a high of 37.5 on Thursday.

As is obvious in the graph above, none of the major stock indexes has escaped unscathed from the current turmoil. And they have lost all or most of their 2007 gains and then some. The worst performers are in Japan where stocks have been buffeted by carry trade unwinds.

Asian markets, hit hardest in the week, had closed before they could react to the Fed move. The Nikkei was down 5.4 percent Friday — its worst daily loss since the September 2001 terrorist attacks. The Nikkei, down 8.9 percent in the week, is now down 11.3 percent from its December 2006 close. Only the FTSE and DAX ended the week with a gain. The indexes that are now down in 2007 include the Nikkei, Topix, FTSE, and CAC.

The Fed acts

The Federal Reserve took emergency steps to mitigate the damage to the U.S. economy from the global credit market crisis. The Bank cut its discount rate by 0.5 percent to 5.75 percent, while keeping the main federal funds rate at 5.25 percent. The discount rate is the rate the Federal Reserve charges when lending reserves to banks directly. This is in contrast to the fed funds rate which is what banks charge other banks when lending spare reserves. The move, which surprised the markets, should improve liquidity and limit the blow to financial institutions from the deterioration in assets exposed to the meltdown in the U.S. subprime mortgage sector.

Global Stock Market Recap

Europe and the UK

Stocks in the UK and Europe began and ended the week on a positive note. On Tuesday and Wednesday, equities were weak and moved downward in the UK and France, but managed to tick upward in Germany on Wednesday. Equities declined amid continued rumors about losses in European banks that were related to woes in the U.S. subprime market. European investors tend to shadow moves in the U.S. However, until Thursday, the declines in Europe and the UK were muted in comparison although intraday moves continued to be volatile. The overriding factor pervading the markets was fear about the health of global credit markets. But what a difference a day makes! After tumbling on Thursday, the three indexes did an about face after the Federal Reserve lowered its discount rate. Equities soared in relief and retained their gains for the most part.

Although the FTSE's losses were broad-based at mid-week, its decline was not as steep as that seen on European exchanges and the index maintained a portion of Monday’s 180 point gain. However, on Thursday the FTSE succumbed to fear and every stock that comprises the FTSE 100 was down on the day. However, with Friday’s rally, the index was in positive territory for the week as was the DAX.

Asia/Pacific

The week began in a mildly positive tone as investors in the Asia/Pacific sought to regain balance after the previous week’s rout. But that deteriorated as each day passed as investors bailed out of carry trade transactions in moves to cut their exposure to risk. The Fed move to reduce the discount rate came too late to prevent Friday’s sell off. On Thursday, politicians and central bankers in the region were trying to reassure investors that a currency realignment and stock market slump would not derail economic growth. However, equities plummeted on Friday, especially in Japan where the unwinding of the carry trade has had a negative impact on stocks as the yen climbed to May 2006 levels.

The Nikkei dropped on Friday to its lowest level since August 2006. Shares plunged on panic selling after the yen surged to 14-month highs against the dollar. Investors sold shares in major exporters on expectations that their overseas earnings will suffer. The Nikkei suffered its sharpest point drop since April 2000 and the biggest percentage decline since March 2001 on Friday. Over the past three days, the index has tumbled over 1500 points and closed the week at its lowest level since August 2006. The panic spurred domestic investors to come back from Japan's unofficial week-long Obon holiday to grapple with the fallout. Overnight the yen strengthened suddenly to its highest level since June 2006 against the dollar as speculative carry trade positions were unwound. Low interest rates have made the Japanese unit the currency of choice for the carry trade in which investors borrow cheaply in yen and reinvest the proceeds in higher yielding and often riskier assets. That has helped keep the yen weak against other currencies as investors sell borrowed yen in favor of other currencies.

Reserve Bank of Australia governor Glenn Stevens, in testimony before a parliamentary economic committee, said that the problems in the global credit market are not sufficient to warrant a change in the central bank's current monetary policy. The RBA had increased its interest rate to 6.5 percent earlier this month. He said monetary policy has to be assessed in terms of whether financial market conditions will impact the global economy and the Australian economy as well as the inflation outlook. Governor Stevens also said that he was not aware of any coordinated action by central banks around the world to intervene in financial markets to reduce volatility. Rather, there has been information sharing between central banks but this is routine regardless of the state of financial markets.

Currencies

The currency markets were dominated by the massive sell off in risk as speculators liquidated their carry trade positions. The yen gained about 3.5 percent against the U.S. dollar on the week. But after the Fed’s move, the yen dropped against all 16 major currencies. The Fed’s move apparently encouraged investors to resume buying riskier assets after borrowing in low interest rate Japan. The unwinding of the carry trade helped inflate the yen and deflate currencies such as the Australian dollar that had previously benefited from the transactions. At week’s end, the Reserve Bank of Australia was forced to intervene to stabilize the foreign exchange market. For the first time in six years, the Bank bought Australian dollars to stem the steepest drop since 1983 when the currency began to trade freely.

With the sharp unwinding of the carry trade, the yen surged against high-yielding currencies like the Australian and New Zealand dollars. In the past three weeks, the New Zealand dollar has dropped about 14 percent against the yen, while the Australian dollar has lost about 10 percent. The pound and the euro also have dropped against the yen. The yen has also advanced against the dollar as the currency has benefited from safe haven buying in the current turmoil and some unwinding of carry trades based on borrowings in the currency.

The U.S. dollar was down against the euro on Friday after the Federal Reserve’s reduction of the discount rate. The dollar weakened against 14 of 16 major currencies as a reduction in borrowing costs dimmed the attraction of U.S. assets. The decline today trimmed the dollar's advance for the week as investors had sought safety in the currency after a global rout of credit markets. The dollar previously had advanced to its highest level in more than two months against the euro after banks and hedge funds scrambled to shed riskier assets.

Indicator scoreboard

EMU — Second quarter gross domestic product was up 0.3 percent and 2.5 percent when compared with the same quarter a year ago. Revised first quarter GDP was up 0.7 percent from the previous estimate of 0.6 percent while the change on the year remained at 3.1 percent. As with all flash estimates, no detail is provided. Geographically, among the members for whom data are available, above average gains on the quarter were posted by Austria (1.0 percent), Spain (0.8 percent), Belgium (0.6 percent) and Portugal (0.4 percent). Sub-par advances were registered by Italy (0.1 percent) and the Netherlands (0.2 percent) while the Greek economy contracted (0.8 percent).

June industrial output edged down 0.1 percent and was up 2.3 percent when compared with last year. The results reflected modest gains by intermediates (0.3 percent) and energy (0.3 percent) that were more than offset by declines in durable (0.1 percent) and non-durable (0.3 percent) consumer goods. Production of capital goods was flat on the month. Among the region members, Ireland posted the largest monthly decline (0.7 percent) followed by France and Italy (both 0.5 percent) and Germany (0.3 percent). The strongest performers were the Netherlands (2.9 percent), Luxembourg (2.3 percent) and Slovenia (2.5 percent).

July harmonized index of consumer prices was down 0.2 percent and up 1.8 percent when compared with the same month a year ago. This was the 13th month in a row that inflation has been below the key 2 percent mark. Excluding energy, the HICP was steady at 2.0 percent while the core rate (excluding food, drink, tobacco and energy) was also unchanged at 1.9 percent. Among the major sectors, the dominant monthly gains were in recreation & culture (1.2 percent) and accommodation services (6.0 percent). Helping to drive the HICP lower were clothing (down 8.2 percent), household equipment (down 0.3 percent) and food (down 0.1 percent).

Germany — Second quarter flash gross domestic product was up 0.3 percent and 2.5 percent when compared with the same quarter a year ago. The quarterly gain was the slowest rate of expansion since the end of 2005. As with all flash releases, no detail was available. However the Federal Statistics Office did point out that growth was supported by very dynamic net exports while slower growth in domestic demand appears to have been led by investment in equipment.

July producer price index was down 0.1 percent and up 1.1 percent when compared with last year for the slowest pace since April 2004. A hefty monthly fall in energy (0.5 percent) made an important contribution, but excluding energy, prices were up only 0.1 percent and 2.4 percent on the year. Among other major sectors, basic goods and capital goods both rose 0.1 percent on the month while the consumer sector saw a 0.3 percent advance on the back of a 0.4 percent rise in non-durable goods. Durables were unchanged.

France — Second quarter preliminary gross domestic product expanded by 0.3 percent and was up 1.3 percent when compared with the same quarter a year ago. However, the local economy picture was rather better than the headline suggests with domestic demand, excluding stockbuilding, adding 0.5 percent points to the quarterly gain. Within that, private consumption grew 0.6 percent and although capital investment was up just 0.1 percent, it followed a 1.2 percent surge in the first quarter. Public sector spending rose 0.5 percent. The major drag came from the international trade sector which saw imports (2.1 percent) easily outstrip exports (1.1 percent). This follows broadly flat contributions from net exports in the previous two quarters and will fuel official concerns about the adverse impact upon competitiveness of a strong euro.

United Kingdom — July producer output prices were up 0.2 percent and 2.4 percent when compared with last year. Core output prices also increased by 0.2 percent on the month and 2.3 percent on the year. The largest monthly gain in the overall index was in food which jumped 0.5 percent, in part almost certainly a function of the particularly wet weather that month. Other advances were much more modest with just chemical and metals products (both 0.3 percent) increasing by more than the average. The sole decline was registered by electrical and optical (0.4 percent). Producer input prices dropped 0.5 percent and edged up only 0.1 percent on the year. Core prices were also down 0.5 percent but were up 1.1 percent on the year. Over the year, the largest sector gains were in imported metals (7.9 percent) followed by other home-produced materials (5.6 percent) and home food materials (4.3 percent). The two categories showing declines were fuel (6.7 percent) and crude oil (4.7 percent). 

July consumer price index sank 0.6 percent and was up 1.9 percent when compared with last year. This is the lowest rate since March 2006 and back below the official 2 percent inflation target threshold. The core CPI also declined 0.5 percent on the month to reduce the underlying inflation rate to 1.7 percent. The main driving force behind the surprise deceleration was food and alcohol which fell 1.7 percent. However there were also sizeable declines in furniture and household equipment (4.2 percent) and communication (1.4 percent). The largest increase was the seasonal increase in transport (1.1 percent). Inflation in the goods sector now stands at just 0.5 percent (June 1.4 percent) and in services at 3.5 percent (3.7 percent).

July claimant count unemployment rate edged down to 2.6 percent from 2.7 percent in June. Claimant count unemployment was down 8,500. This was the lowest rate since April 2005 and matches the previous low set in April 1975. According to the International Labour Organisation measure, the unemployment was 5.4 percent in the three months to June, down 0.2 percent from the previous quarter and 0.1 percent below the year ago figure. The number of unemployed stood at 1.65 million, a drop of 45,000 from the first quarter level and the largest drop since the December 2003 quarter. With the number in employment increasing by 93,000 and vacancies up a solid 14,900, this report confirms other indicators of a steadily tightening labor market.

Average earnings for the three months ending in June dropped to 3.3 percent from 3.5 percent in the previous three months. Wages are now growing at their slowest pace in four years rate and, moreover, with the annual change in the June index alone at just 3.1 percent, could well fall even further next month. Although the latest deceleration was in part a function of lower bonus payments, even excluding this category earnings growth still slipped a notch to 3.4 percent, the slowest pace since July 2003.  Furthermore, it was softer private sector pay (3.4 percent from 3.6 percent) that drove down the headline rate with the public sector holding steady at an already subdued 3.1 percent. Pay rates in manufacturing actually edged higher (3.8 percent from 3.7 percent) but the more important services area saw a fall (3.3 percent from 3.5 percent).

July retail sales were up 0.7 percent and were up 4.4 percent when compared with last year despite the record setting rains during the month. However, while the data look strong, they need to be seen in the context of very heavy discounting on big ticket items. This is reflected in the weakness of the retail sales deflator which now stands 1.1 percent below the June 2006 level, the largest decline since April 2006. Most of the monthly growth came from non-food stores (1.0 percent) while the food sector (0.1 percent) lagged well behind. Food sales are now down 0.8 percent on the year but this is probably misleadingly weak with July 2006 having been boosted by particularly good weather and the World Cup. Almost certainly affected by the heavy rain, clothing & footwear were off 0.5 percent versus June and, combined with a 0.3 percent drop at non-specialized stores, was the only major sector to post a decline.

Asia/Pacific

Japan — Second quarter preliminary gross domestic product edged up 0.1 percent from the previous quarter or at an annualized rate of 0.5 percent. This was the 10^th consecutive quarter of growth in the recovery phase that began in 2002. When compared with the same quarter a year ago, GDP was up 2.3 percent. This was far weaker than the annualized 3.2 percent increase in the first quarter of 2007 and the fourth quarter 2006 increase of 5.4 percent. Both exports and consumption decelerated. Private consumption growth slowed to 0.4 percent from double that in the previous quarter. However corporate spending on factories and offices gained 1.2 percent on the quarter, a significant improvement over the first quarter’s 0.3 percent increase. The GDP deflator dropped 0.3 percent as it did in the first quarter. But the domestic demand component of the deflator was up 0.2 percent after declining 0.1 percent in the previous quarter.

June tertiary activity index edged up 0.1 percent to offset May’s 0.1 percent decline but was up 1.7 percent when compared with the same month a year ago. Activity picked up for medical, health care & welfare, eating & drinking places, accommodations, finance & insurance, compound services, transport and real estate. Industries that contributed to the decrease were information & communications, wholesale & retail trade, learning support, electricity, gas, heat supply & water. The service sector employs more than half of Japan's workforce, and spending on services such as retailing, dining and travel is closely tied to changes in income and consumer confidence.

China — July consumer price index hit a 10-year high of 5.6 percent when compared with last year. Food prices — particularly meat and poultry — were the main drivers behind the increase from June's 4.4 percent reading. Food prices which account for about 33 percent of the CPI, climbed 15.4 percent after a shortage of pigs pushed up meat prices and bad weather destroyed crops. Non-food CPI continued to be moderate, increasing at a 0.9 percent rate.

July industrial production was up 18 percent when compared with the same month a year ago. This is marginally slower than June’s increase of 19.4 percent on the year. For the first seven months of 2007, industrial production was up 18.5 percent when compared with the same months a year ago. Raw steel output was up 14.5 percent, somewhat less that the 18.9 percent growth on the year in June. Industrial output data are generally viewed as a reasonable proxy for overall economic activity, since China's statistics are generally considered more reliable on the production side than the expenditure side.

Americas

Canada — June merchandise trade surplus narrowed to C$5.3 billion from C$5.9 billion in May. Exports (1.0 percent) declined for the third month while imports posted a small advance of 0.6 percent. Key to the drop in exports was the largest fall in the machinery and equipment sector (4.2 percent) in 15 months reflecting an unwinding of some of the recent particularly strong gains posted in aircraft and other transportation equipment. There was also a decline in exports of automotive products (1.7 percent) as some plants closed earlier than usual in preparation for the production of new models. At the same time forestry products were down 1.2 percent, the third drop in a row and a further illustration of the impact of Canada's strong dollar. Among imports, industrial goods & materials were up 3.6 percent, machinery & equipment 0.7 percent but autos fell 3.8 percent and other consumer goods dropped 1.6 percent. Energy imports were down 1.0 percent. The bilateral trade surplus with the U.S was little changed at C$7.7 billion but with the rest of the world the deficit widened to C$2.4 billion.

June factory shipments sank 1.8 percent, the largest since January and the third monthly decline in a row. On a sector by sector basis, 13 of the 21 manufacturing industries posted declines although, probably reflecting Canadian dollar strength and a weak U.S. auto market, motor vehicles and parts were especially soft (down 13.3 percent). Excluding this category, shipments were down 0.5 percent. Durable goods manufacturers posted a 3.2 percent drop while non-durables slipped 0.3 percent. New orders dropped 1.0 percent but it was not all bad news since unfilled orders jumped a healthy 2.0 percent so there may be a recovery in the pipeline soon.

Bottom line

What started as a week when perhaps the financial markets would stabilize rapidly deteriorated as investors continued to shed equities for more risk averse assets. Investors don’t like uncertainty, and at present they have no idea of the magnitude of the subprime problem or where it resides. 

This week, the Bank of Japan meets. Analysts are no longer certain that the BoJ will increase its interest rate above its current 0.5 percent given the present turmoil in the financial markets. But many professionals think that higher interest rates in Japan would ameliorate some of the carry trade problems currently being experienced.

Looking Ahead: August 20 through August 24, 2007

Anne D Picker is the author of International Economic Indicators and Central Banks.