The US dollar remained rather resilient in the face of disappointing US economic news and the gradual shift of opinion to the recession camp. The minutes of the Fed's March 18 meeting revealed that many Fed members considered a contraction in US growth as "likely", and with the more pessimistic among them seeing the risk for a "prolonged and severe" downturn. The IMF also revised downward its forecast for US growth in 2008 to 0.5% from 1.5%.

While the Fed is expected to have to further cut interest rates to revive the growth engine, it will not be alone as other central banks are likely to join in as their countries gradually feel the impact of the US housing and credit problems. The IMF said that Europe was particularly vulnerable to financial spillovers from deeper credit market problems in the US, while a possible correction in some of Europe's housing markets could also weigh on consumer confidence and spending.

The UK has already started easing rates, the latest being the 25 bp cut to 5% at its April 10 meeting as its own housing slump and higher credit costs cut into the growth of its financial services industries and consumer spending. While the European Central Bank kept rates unchanged at 4% on the same day and ECB President Trichet said that inflation remained a concern, he also acknowledged that the credit crisis posed a risk to euro zone economic growth. As such, the ECB is expected to have to cut rates down the road. When it happens, it would reduce the interest rate differentials that have been underpinning the latest euro rally. In the event, although the dollar could come under short term selling pressure on negative credit and economic news, the trend could reverse as soon as signs of a slowdown in the euro zone become evident.

The credit crisis that has been gripping financial markets shows early signs of stabilizing but the US economy remains at risk of falling into recession, indicating that US rates are likely to be cut further.

Latest economic data show that tighter financial conditions, higher energy prices and softer labour market conditions are threatening to push the US economy into recession. The minutes of the Fed's March 18 meeting also revealed that many Fed members considered a contraction in growth as "likely", and with the more pessimistic about them seeing the risk for a "prolonged and severe" downturn. In addition, the IMF revised downward its forecast for US growth in 2008 to 0.5% from 1.5%.

Despite the economic gloom, there are early signs that the Fed's effort to inject liquidity are helping ease some of the intense strains in financial markets. The so-called TED spread, the difference between 3-mth LIBOR and 3-mth Treasury yield, narrowed to around 150 bp from 200 bp in late March. The latest figures also show that US primary dealers’ need for Treasuries and cash from the Fed, albeit at still-hefty levels, eased in the latest week. Slim demand at the Fed auction of Treasury securities also signaled the tense demand among primary dealers for government securities in exchange for cash in the repurchase market may be abating. However, the situation for banks outside of US does not seem to have improved as the persistently high LIBOR suggest that they are still having difficulty in getting short term dollar funding.

With the US economy remaining weak and credit crisis yet to be over, the Fed would have little choice but to further cut interest rates, perhaps to as low as 1% this year. In contrast, the ECB is still quite hawkish, but it too will have to start cutting rates if more weak economic reports emerge, probably in the second half of this year.

It is almost official. While US authorities and IMF officials avoid using the word recession in their assessment of the US economy, they acknowledge that the risk to growth is rising and that the US economy might be stalling under the weight of tighter financial conditions, higher energy prices and softer labour market conditions.

The minutes of the Fed's March 18 meeting revealed that many Fed members considered a contraction in growth as "likely", and the more pessimistic members even seeing the risk for a "prolonged and severe" downturn. The IMF also revised downwards their forecast for global growth as they said that the housing and credit problems in the US were exacting a heavy toll on the global economy. It also cut its US growth forecast for 2008 to 0.5% from a previous forecast of 1.5%.

Such pessimism seems justified as US economic reports continued to disappoint, showing persistent weakness in the housing and labour markets.

US pending home sales, reflecting the number of Americans signing contracts to buy previously owned homes, showed that the housing downturn has yet to bottom. Sales declined 1.9% mom and 17.4% yoy in February, more than consensus forecast. It was also the lowest reading since records began in 2001.

US employers also cut jobs for a third month, with nonfarm payrolls declining 80,000 in March, worse than consensus forecast of a drop of 50,000. The figure for February was also revised lower from a loss of 63,000 to 73,000 jobs. Among the major industries, factories and construction eliminated 48,000 and 51,000 jobs respectively, while services added a mere 13,000 workers. The unemployment rate also rose to 5.1% in March from 4.8% in the previous month.

The US external sector may be the only bright spot but it is unlikely to be able to cushion the negative impact of housing on consumer and investment spending. While the trade deficit widened more than expected to USD62.3 billion in February, the situation is likely to improve as a weak dollar would help improve the competitiveness of US exports in overseas markets while imports slow on the back of weak consumer spending.

In view of strong inflationary pressures resulting from rises in energy and food costs, the European Central Bank left its benchmark interest rate unchanged at 4% after its regular policy meeting on 10 April. Maintaining price stability remains the highest priority to the central bank, although the recent turbulence in financial markets threatens the output growth in euro area.

Indeed, prospects for inflation in the near term had deteriorated. The headline CPI in the region was estimated to rise by 3.5% yoy in March, the highest since the euro was launched in 1999. The ECB also expects that the annual inflation will stay significantly above its inflation target of 2% in the coming months before moderating gradually later this year.

Nevertheless, in light of strains in financial markets and the sluggishness of economic activity in the US, the level of uncertainty in the eurozone is high. According to Eurostat's final estimate, the region's fourth-quarter real GDP growth was 2.2% yoy, down from 2.7% yoy in the third quarter. In particular, real consumer spending rose at a much reduced pace 1.1% yoy after an increase of 1.7% yoy in the previous quarter.

The International Monetary Fund forecasts that annual output growth for the euro area would fall to 1.4% in 2008 from 2.6% last year. The projection was largely based on considerations that the impact of a slowdown in the US would feed through to the region's economy and a tightening of lending standard as a result of the credit crisis would weigh on business investment and household spending.

Overall, the near-term economic outlook has weakened but fears over inflation are mounting. The ECB is likely to continue monitoring the economic developments and maintaining the current monetary policy stance for some time. When there is enough evidence of a widespread slowdown in the economy, the central bank may have little choice but to start an easing cycle.

The Bank of England decided to cut interest rates for the third time since last December by 25 bp to 5.00% at its regular meeting on April 10, matching consensus forecast, as worries that higher credit costs and the housing slump would put the UK economy into a recession.

Meanwhile, in its semi-annual World Economic Outlook, the IMF cut the forecasts for the UK economy and stated that the Bank of England has room to cut interest rates. The Fund predicted that the economy would grow a mere 1.6% this year and next.

Growth in the manufacturing sector was subdued in March. According to the Chartered Institute of Purchasing and Supply, the manufacturing index was held at 51.3 in March, below consensus of 51.6. To the market participants’ surprise, however, industrial production increased by 0.3% in February following a 0.1% decline in the previous month. However, this may be considered short-lived given forward looking indicators point to a slowdown.

In the meantime, the services PMI index dropped to 52.1 in March, the weakest since November 2007. As a matter of fact, both the manufacturing and services PMI indexes have been on a declining trend over the past few months, indicating that growth in the sectors would continue to moderate.

In fact, the economy could be further hammered by a slump in the housing market. According to a report by HBOS, house prices fell for the second month in March. Home values dropped by 3.5% mom in the month following a 0.4% decline in the previous one.

Meanwhile, mortgage approvals also stayed at a nine-year low in February as banks continue to tighten credits. Lenders approved 73,000 loans for home purchase, the second lowest since record began in January 1999.

The only encouraging news came from the external sector. Trade deficit improved to GBP7,487mn in February from GBP7,924mn in the previous month, mainly helped by record oil sales.

The Bank of Japan, as widely expected, voted unanimously to keep the overnight call rate unchanged at 0.5% at its latest meeting on April 9. Masaaki Shirakawa, the newly appointed BOJ Governor, remarked at the press conference that "higher energy and raw materials costs are causing the economy to slow now". In its latest monthly report, the Bank described the country's economic growth as "slowing" rather than "expanding moderately". Given accelerating inflation but lackluster economic growth, the central bank seemed to have no choice but to maintain interest rates on hold for a longer period of time.

Recent economic data largely supported this point of view. The Tankan survey, a forward looking indicator, shows that business confidence fell to a four-year low. According to the Bank of Japan, the quarterly Tankan index of manufacturer sentiment plummeted sharply from 19 in the fourth quarter last year to 11 in the first quarter this year.

The index for non-manufacturer sentiment also dropped from 15 to 12 during the same period as corporates were concerned about worsening business conditions in the light of the recent rise in the Japanese yen exchange rate and the uncertain outlook for global growth. Large enterprise planned to cut capital spending by 1.6% this fiscal year.

Meanwhile, machine orders resumed its downward trend in February following a short-lived rebound in the previous month. Machine orders, an indicator of capital spending in the next three to six months, declined by 12.7%. Among which, manufacturing orders dropped 13.2% mom while non-manufacturing orders dropped at a larger extent of 13.3%.

On a seasonally adjusted basis, current account surplus narrowed to JPY1,461.1bn in February, compared with that of JPY2,074.7bn in the previous month. This was mainly due to a sharp decline in trade balance to a mere JPY486.0bn from JPY1,079.8bn.

It seems that economy conditions in Japan would remain dim going forward.

Click here to download full report.

Global Market Intelligence (April 14, 2008). Hang Seng Bank Limited. All rights reserved. Reproduction of article(s) in whole or in part is permitted provided the source is quoted. Please direct any inquiry to Treasury, Planning and Research Department, G.P.O. Box 2985, Hong Kong.