Eric Vergnaud, 10^th  - 18^th  July  2006

Crises

The sudden increase in geopolitical tensions with the military escalation between Israel and the Lebanese Hezbollah has fuelled a new surge in crude oil prices to almost USD 80, a rise of 13% on the previous month. In turn, in what has become a classic scenario, equity markets have registered sharp falls and bond yields have come down (from 5.14% to 5.07% on the US 10-year T-note and from 4.10% to 4% for the German Bund of the same maturity). Once again, investors fear that high energy prices may both squeeze profit margins (via the drop in activity and a rise in production costs) and lead to higher inflation. So, once again, the question arises over the ability of the world economy to absorb this additional shock. Among the positive points is the good financial health of companies, which on average in all developed countries have reduced their borrowings and are reporting record profits. In addition, liquidity remains abundant. Nevertheless, interest rates are higher than a few months ago with the yields on 10-year government bonds having risen by about 50 basis points since the start of the year. Furthermore, the worldwide monetary tightening has increased short-term financing costs and changed investors' attitudes towards risk.

This week, the outlook for US monetary policy will take centre stage with the publication on Wednesday of the consumer price index for June and Ben Bernanke's Humphrey Hawkins Testimony to the Senate the same day. The Fed Chairman's remarks are likely to be extremely balanced, by underlining both the need to control inflation so as to ensure the maximum long-term growth and the undeniable current slowdown of the latter. Thus, retail sales fell by 0.1% m/m in June, which brings their annual rate of increase in Q2 to 3.7%, well down on the 13.4% rate of growth in the previous quarter. Softer activity in the property sector is leading to a clear-cut contraction in purchases of building materials, while the rise in energy prices is hitting car sales, which registered a second marked fall and whose annual rate of change has moved back into negative territory (-3.5%). True the automobile sales data used in the GDP calculation showed a sharp rise in June of 1.9% and spending on building materials does not come into the calculation of household spending in the national accounts. But the slowdown in activity is obvious. Mr. Bernanke could repeat that this is sufficient to control inflation and take it back by the end of next year to the Fed's comfort zone. Under these circumstances, the scenario of a pause in the cycle of monetary tightening should gain credibility among financial market operators.

In Japan, the zero-interest rate policy that has been in force for the past five years ended with last Friday's hike of the BoJ's overnight rate to 0.25%, while the official discount rate -- effectively the maximum short-term rate -- went from 0.10% to 0.40%. However, BOJ governor Fukui made it clear that this was not the start of a series of rises. While prices increased once again in May and growth appears fairly robust and well balanced between domestic demand and exports, and the newly re-discovered financial health of Japanese companies means they can easily self-finance their capital expenditure, the government has urged the BoJ to adopt a prudent and gradual approach. In any event, last week's hikes give the BoJ once again (very) slight room for manoeuvre if the slowing of the world economy, of which we are already seeing the foundations being laid, proves to be sharper than expected.

United StatesEuro ZoneJapan