Weekly Commentary 25 November 2011

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1 Produced by the Economic Research Unit Corporate Treasury Business Banking Treasury Institutional Treasury Property and Specialised Finance (01) UK Sales Team (UK only) US Sales Team Full contact details for all departments click here ( Weekly Commentary 25 November 2011 Economic Research Unit: (01) Themes from the week Poor German debt auction spooks markets Headlines for the week ahead Employment report and ISM manufacturing index in the US Yields rise, euro falls on debt concerns The euro area debt crisis took a new twist as a poor bond auction caused a spike in German yields 10-year bond yields ended the week almost 30bps higher and prompted a sharp rise in yields on other EMU member countries debt Italian 10-year yields rose by almost 70bps to over 7.2% while equivalent Greek, Portuguese and Irish yields soared by over 100bps. The single currency also weakened notably, amid concern that investors are shunning euro assets, falling by around 3 cent against the dollar to $1.32. Merkel, Sarkozy, and the new Italian PM, Mario Monti, met on Thursday and agreed to shortly put forward proposals for Treaty change encompassing greater co-ordination and surveillance of budgetary policy in the zone, though not, as Merkel made clear, extending to the remit of the ECB. The latter is prohibited under the current Treaty from the monetary financing of Euro area governments (i.e. intervening directly in the primary government debt markets), though it is allowed to do what it is currently doing (and may have to do more of), which is buying government bonds in the secondary markets. The prospect of a renewed contraction in the euro area economy has also risen, judging by the latest survey data. The Purchasing Managers measures of activity in the manufacturing and services sectors both remained well below the 50 level again in November (notwithstanding a rise in the services index), which is consistent with a decline in GDP in the final quarter of the year. The ECB will have its staffs latest macroeconomic projections when it next meets on December 8, and they should be the hook on which to hang another interest rate cut following the 25bps reduction at this month s meeting. The UK economy expanded by 0.5% in the third quarter according to the second estimate of GDP, after growing by just 0.1% in Q2. However, the composition of growth, which was heavily slanted towards stockbuilding, suggests the pace of activity will slow again in the fourth quarter. The minutes of this month s Bank of England MPC meeting noted that the current 75 of government bond purchases will take a further three months to complete. In the intervening period, the MPC will assess the impact of these purchases on the economy and monitor developments in the euro area. While some members believe that a further expansion of the asset purchases programme might yet be necessary, there are unlikely to be any developments on this front until February, when the next inflation report is due. Sterling ended the week little changed against the euro at just over 85p, though it did lose ground to the dollar. Michael Crowley Data section contents (changes on the week) Long term rates Highlights for the week ahead Commodities Prev Fcst Cons Mon Euro Area M3 3.1% 3.4% 3.4% IRL Retail Sales -0.9% - - US New Home Sales 313k 310k 310k Tue EA Economic Sentiment US Consumer Confidence Wed EA CPI 3.0% 3.0% 3.0% US ADP Employment 110k 130k 130k Fed Beige Book Thurs US ISM Manufacturing , UK PMI Manufacturing Fri US Employment Report 80k 120k 120k Spot rates US Unemployment Rate 9.0% 9.0% 9.0% More details in data section EUR/GBP EUR/CHF EUR/USD EUR/JPY GBP/USD EUR/CAD EUR/SEK EUR/PLN EUR/NOK EUR/ZAR EUR/HUF EUR/CZK Interest rate swap rates More details in data section 2 year 3 year 5 year 7 year 10 year 15 year 20 year EUR GBP USD Official rates More details in data section Current Q4 11 Q1 12 Q2 12 Fcst Cons Fcst Cons Fcst Cons EUR GBP USD Recent research See all recent research ( See most recent versions of: The Bulletin (monthly analysis of international and Irish markets) UK View (quarterly analysis of trends in the UK economy) The Outlook (quarterly analysis of trends in the Irish economy) Irish Property Review (quarterly analysis of Irish property trends) Irish Business Review (quarterly research, analysis and commentary) All rates quoted are indicative market rates

2 Data section contents Data section showing % changes on the week Long term fixed rates Commodity prices Europe Crisis spreads to Germany Last week we saw the effects of the debt crisis reach into more countries with France, Austria and Belgium coming under scrutiny and yields rising on their government debt. This week, Germany, viewed as the stable core of the Euro area, saw its yields surge following a poorly received debt auction. This was previously unthinkable but really it was inevitable that the debt crisis, which started over two years ago in Greece, would eventually reach into every corner of the Euro area. Investors are losing interest in buying German debt given the low yields on offer (10-year yields were just 1.98% at Wednesday s auction) and the inherent risks to Germany from further problems in other EA states. Yields rose sharply on every Member State s debt after the German auction on Wednesday. European investors might wish to take their funds of out of peripheral debt and put it into bunds (to avoid currency risk) but investors outside of Europe are now signalling they want to avoid any Euro area debt, even the previously invincible German debt. German 10-year yields rose by 15bps immediately after the auction (where just 60% of the debt on offer was bid for) and are now around 2.2% - still the lowest in the Euro area compared to 10-year US Treasury yields of around 1.9%. There has been a sharp reversal of the spread between bunds and treasuries; as little as two weeks ago 10-year bund yields were about 30bps lower than equivalent treasury yields. Adding to the Euro area problems are increasing concerns that France may be downgraded from its AAA status, with rating agencies indicating that another fiscal shock to France would be enough to justify a downgrade. It s now clear that containment of the debt crisis has failed and, even if a member state is solvent with solid public finances and a strong economy, if you are in the EA then you are in trouble. If Germany is having difficulty selling debt in this current environment then it s going to be very big challenge for everybody else in the EA to sell debt in the short term. This development in Germany may, however, soften German objections to some of potential solutions to the debt crisis. They remain opposed for now to commonly issued Eurobonds and/or unlimited debt purchases by the ECB, but perhaps Germany might come around to thinking those solutions may not be the end of the world if they can finally end this saga. Talks are going on in the background but in the meantime the situation is likely to continue to worsen if there are more poor debt auctions by member states. Not surprisingly, the Euro had a losing week; falling to $1.33 from close to $1.36 in the days before the German auction. Ireland Residential housing market yet to bottom Residential house prices continue to slide in Ireland. Nationally, the average residential property price fell by 2.2% in the month of October, leaving the annual decline at 15.1%. In Dublin, property prices fell at a faster pace in October, down 3.1%, leaving the annual drop there at 17.5%. There was some false promise in data for Dublin property prices over the summer, when the pace of decline moderated, however it has accelerated again in the past 3 months. Dublin property prices have declined at an average rate of 3% over the 3 months to October compared to an average decline of 0.7% in the 3 months to July. A bottom to the market does not appear imminent but the consensus view is that the trough will come sometime next year. On our models, affordability is at its strongest for a decade. However, the decision to buy or rent is influenced by other factors such as the economic outlook and expectations of house price changes. The factors seem to be weighed in favour of renting at the moment as, while house prices have declined, data indicates that rents have stabilised. United Kingdom MPC signals that more QE might be on the way The MPC minutes from the November meeting showed that the Committee voted 9-0 in favour of keeping interest rates on hold and at holding the asset purchase program total at 275bn.The minutes noted that growth had been weak throughout the year and that a fall in real incomes, tight credit conditions, continuing fiscal consolidation, deterioration in the global outlook and strains in the financial markets meant that the outlook for growth next year is significantly weaker now (in the current November inflation report) than in the August inflation report despite the current forecasts assuming lower interest rates and more asset purchases. The outlook for growth is unusually uncertain and the concerns over the Euro area debt crisis has led to widespread falls in confidence. While the worst risks (associated with the debt crisis) had so far not crystallised, the threat of an escalation had increased. The debt crisis needs a credible and effective policy response that reduces uncertainty and this would help the UK and global economies. Failure (by Europe) to meet these challenges would have significant adverse consequences for the UK. On inflation, the committee s central view remains that inflation should fall sharply by the end of 2 Bank of Ireland Global Markets

3 Data section contents Data section showing % changes on the week Long term fixed rates Commodity prices the first part of 2012 although there is greater uncertainty about the pace at which it would continue to fall thereafter. The minutes also note the key upside risk is that elevated inflation would be more persistent than the committee expected due to a number of factors, including if expectation of above target inflation become embedded in wage and price setting. This has to be a concern as inflation has been consistently well above target for nearly two years now and three out of past four years have had much higher inflation that the target. That said, there also remains evidence of a large output gap given below trend growth, and the amount of spare capacity in the near term is likely to increase, which should contain inflation pressures. Weak growth, rather than the current elevated inflation rate, is the key concern for long term price stability, and the minutes noted that, while GDP had risen by 0.5% in Q3, underlying growth was, however, likely to have been a little weaker, meaning the committee is very likely to have a continuing bias toward further easing. The impact of any further QE announcement is limited by the fact that the existing programme of asset purchases would take a further three months to complete and market capacity made it difficult to increase the monthly rate of purchases substantially above what was already under way but some members still noted that the balance of risks to inflation in the November Inflation Report projections meant that a further expansion of the asset purchase programme might well become warranted in due course; anticipation of that might itself have an effect on asset prices and demand. All in all, the position remains that the MPC continues to indicate that more QE might be in the offing, but it might have to explore new ways of doing so if the current strategy becomes constrained. United States Equity markets fall, government bonds rallied It was a holiday-shortened week on account of Thanksgiving Day on Thursday, and markets were relatively quiet ahead of it. They still, though, generally took their cue from Europe, so stocks ended lower and government bond yields fell amid an escalation of the euro area debt crisis. There were some data releases of note, with the latest personal spending report, which showed an increase in consumption of 0.1% in real terms in October after a 0.5% gain in September, suggesting growth in this component of GDP in Q4 should broadly match the Q3 increase of 0.6%. The pickup in consumer spending from the middle of the year (spending didn t increase at all in the three months to June) has been facilitated by a notable fall in the personal saving ratio. It is unlikely to decline much further, and indeed may start to rise, so if consumer spending growth is to be sustained at a reasonable pace there would need to be some pick up in incomes and employment. The latest data provide some encouragement in this regard, with real disposable incomes rising by a reasonably healthy 0.3% (or 3.6% at an annualised rate) last month and the number of new jobless claimants remaining below the 400k level for the third consecutive week last week, the latter consistent with some acceleration in the pace of employment growth (next Friday sees the release of the employment report for November). With GDP growth having been revised down to 2% (from an initially reported 2.5%) the available data point to growth of at least that, and probably somewhat stronger, in the final quarter of this year. That would still be relatively disappointing from the Fed point of view and so would still leave open the possibility of it announcing further stimulus for the economy. The minutes of its last meeting, published this week, revealed that a few members at least believed further stimulus would be necessary to support the recovery. Japan Japan warned to correct public finances The S&P ratings agency warned Japan this week that it risked a downgrade in its sovereign rating due to the failure to tackle the problems in their public finances. An S&P director said that Japan s finance s are getting worse and worse every day and that it may be right in saying that we re closer to a downgrade. However, he clarified this to say that the deterioration has been gradual so the agency was not preparing for an immediate downgrade, more that this was a warning as the situation was not being tackled by Prime Minister Noda s administration and it was unrealistic for Japan to think it can escape the fallout out from the European debt crisis given its own heavy debt burden. Despite Japanese bond yields remaining at very low levels, the IMF warned this week that Japan was at risk from a sudden spike in yields (in the current market turmoil) and that such an event would quickly make the county s debt level unsustainable given the public debt is already well north of 200% of GDP. The report said the Japanese economy needs widespread reforms, including improving 3 Bank of Ireland Global Markets

4 Data section contents Data section showing % changes on the week Long term fixed rates Commodity prices competition in sheltered sectors, raising labour force participation, higher consumption taxes and pension reform. 4 Bank of Ireland Global Markets

5 Data section changes on the week EUR/GBP Spot % 1M 3 3M 19 6M 37 12M 74 EUR/USD Spot % 1M 1 3M 18 6M 37 12M 73 GBP/USD on the week Spot % 1M -4 3M -13 6M M -47 EUR currency pairs EUR/CAD % EUR/AUD % EUR/NZD % EUR/CHF % EUR/JPY % EUR/SEK % EUR/NOK % EUR/HUF % EUR/PLN % EUR/ZAR % EUR/CZK % USD currency pairs USD/CAD % USD/AUD % USD/NZD % USD/CHF % USD/JPY % USD/CNY % USD/MXN % USD/SGD % USD/BRL % USD/THB % USD/ZAR % GBP currency pairs on the week GBP/CAD % GBP/AUD % GBP/NZD % GBP/CHF % GBP/JPY % GBP/SGD % GBP/MYR % GBP/NOK % GBP/HKD % GBP/SEK % GBP/DKK % GBP/ZAR % on the Week Base O'night 1 week 2 week 1 M 2 M 3 M 6 M 9 M 12 M EUR GBP USD Interest rate swap rates on the Week 2 year Chng 5 year Chng 7 year Chng 10 year Chng EUR GBP USD Government bond yields (YTM) on the Week 2 year Chng 5 year Chng 10 year Chng 30 year Chng Ireland , Germany US UK Prime Rate Bank of Ireland prime rate 1.73 on the Week ISEQ % DOW Jones % S&P % SMI % Nasdaq % FTSE % Eurostoxx % Nikkei % Commodities on the Week Brent % WTI Cushing % Gold % Wheat % Emissions Allowance % 5 Bank of Ireland Global Markets

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