Switzerland: A look back at July

It is four weeks since the last issue of Weekly Focus, so there is good reason to take a look back at the most important events in the Swiss market over the past month. Macroeconomic data have generally been on the weak side, and a look at how incoming data have compared with consensus expectations (as illustrated by the "surprise index" in the chart below) shows that the market has also generally been disappointed. This was confirmed most recently by an unexpectedly sharp drop in the KOF leading indicator, which fell to 0.90 in July, dragged down by a weak outlook for domestic consumption, whereas the financial sector seems to have stabilised. Besides relatively weak activity data, consumer price inflation in Switzerland remains high, hitting 3.1% y/y in July, the highest rate for almost 15 years. Once again inflation was fuelled by higher prices for energy and other imported goods.

All in all, the data for July confirm our view of the Swiss economy: (i) the economy has peaked and growth is expected to slow significantly; (ii) inflationary pressures have mounted, albeit less markedly than in Euro-land; and (iii) the labour market is still strong but indicating an imminent downturn.

This situation was reflected in the financial markets in July. Swiss yields fell, primarily on instruments with short maturities, and so the yield curve has steepened. The yield spread to Euroland (2Y swap yields) hit a new peak of 198bp the day before the ECB raised its key rate by 25bp on 3 July, but has since narrowed again and is currently at 188bp. This narrowing of the spread is mainly due to the market no longer dis-counting further interest rate hikes from the ECB. The market is, however, pricing in at least one further 25bp hike from the SNB in the next year, with a 28% chance of the SNB raising its target range by 25bp at its September meeting.

Movements in the FX market have been rather surprising. CHF fell 1.5% against EUR in July, sending CHF/DKK down from 4.63 to 4.57, and was second only to the NZD as the worst-performing G10 currency against EUR over the month. This was a surprise, as there were only comparatively small movements in relative yields, whereas there were broad falls in the stock markets. This should have led to a stronger CHF, as historically the CHF has performed when stock markets fall. However, this was not the case in July, which indicates that the negative correlation between CHF and the stock market has weakened recently.

Key events of the week ahead

• Monday brings the PMI for the manufacturing sec-tor.
• On Friday it will be interesting to see whether there are again early signs of weakness in the Swiss la-bour market

USA: Fed to signal lengthy period on hold

The big event of the week stateside is the FOMC's rate-setting meeting on Tuesday. In line with both the market and the consensus of analysts, we expect the Fed to leave the funds rate unchanged at 2.0%. As the interest rate decision is therefore largely a given, the focus will instead be on the wording of the accompa-nying press release.

This will make particularly interesting reading in the light of the growing disunity on the FOMC (see Flash Comment - FOMC: Hawks and doves in bird-fight, 17 July). In his semi-annual testimony to Congress in mid-July, Fed chairman Ben Bernanke stepped up the emphasis on growth concerns in the light of the financial crisis (see Flash Comment - FOMC: Growth concerns return, 15 July). However, several of the hawks on the FOMC have since been putting out a very different message, arguing strongly that mounting inflation risks warrant the tightening of monetary policy sooner rather than later. This disunity means that the press re-lease will necessarily end up a compromise between the two camps. That said, it would not come as a sur-prise if one or more of the hawks vote against the interest rate decision.

However, the doves are still in the majority on the FOMC, which gives good reason to expect a moderate statement sticking relatively closely to the message in Bernanke's testimony. All in all, this means that there will be slightly greater emphasis on the downside risks to growth than after the last FOMC meeting, while inflation concerns will be kept at a high but unchanged level. The FOMC is therefore expected to signal that the current funds rate is appropriate in terms of inflation and growth risks, but that the outlook is sub-ject to considerable uncertainty.

We still expect the Fed to stay on hold well into 2009. Generally speaking, we find it hard to see the Fed normalising monetary policy for as long as unemployment is rising, house prices are falling and financial markets are fragile. The latest drop in commodity prices may also help allay inflation fears in the coming months. Against this background, the market's pricing in of a 30% chance of an interest rate hike in Sep-tember seems a tad aggressive to us (see also Fixed Income article).

Key events of the week ahead

• The Fed's Senior Loan Officer Opinion Survey on Bank Lending Practices.
• Tuesday: Core PCE deflator will climb 0.3% m/m or 2.3% y/y in June.
• Tuesday: The FOMC will leave the funds rate at 2.0% and deliver a neutral press release.
• Friday: Unit labour costs will climb 1.4% q/q AR or 1.4% y/y in Q2.