NEWS / Foreign Exchange

Euroland: More positive surprises coming up

• In spite of a significant slowing in the global industrial cycle since last summer, business confidence in Euroland has hardly been hit. Likewise, the German VAT hike has not dampened confidence in the German retail sector, and German manufacturing seems also to have ignored the plunge in consumer demand in Q1. While we have been confident in the underlying strength of the economy, and growth above trend in H2-2007, we have been surprised to see above trend growth in H1-2007.
• Looking forward, the question is whether growth will actually re-accelerate in H2-2007 from its already currently strong level . The most positive factor for Euroland manufacturing will be the reacceleration in global industry, which is already underway in USA and China. Furthermore, German consumer confidence is bouncing leaving much of the VAT related problems behind, and suggesting that the small brake on business confidence will also disappear. These factors are likely to contribute positively to Euroland manufacturing throughout 2007 and into the beginning of 2008.
• On the other hand, the tightening of financing conditions in Euroland via higher short rates and the strengthening of the euro are likely to dampen manufacturing activity and confidence. However, the effects of this tightening are only likely to appear very gradually and last throughout 2008. The net result for Euroland exports and manufacturing is likely to be continued strong growth significantly above trend throughout 2007. However, during 2008 we are looking for significant a slowing of the economy, as global industry turns around and tighter financing conditions also weigh on the economy.
• Continued resilience in Euroland manufacturing throughout 2007 will be a positive surprise. Furthermore, it has important implications for monetary policy, as ECB policy usually correlates well with business confidence, and further tightening is therefore very likely in Euroland during H2-2007. Thus, we revise up our expectations for ECB policy so that we now expect the ECB to hike three times more in 2007 bringing the policy rate up to 4.5% by yearend. The ECB is likely to peak at 4.75% by Q1 next year.