EUR/USD

EU reached a deal with Italy

The European Commission reached a deal with Italy over the country's 2019 budget that avoids an EU disciplinary procedure against Rome, Commission Vice President Valdis Dombrovskis said. He added the decision could be revised in January if Rome did not fully apply the agreement reached with Brussels. Under the compromise, Italy has lowered its headline deficit for next year to 2.04% of output from 2.4% it had planned earlier.

The more important structural deficit, however, which excludes one-off items and business cycle swings, will not change in 2019 from 2018 levels. Under EU rules, Rome was supposed to reduce the structural deficit by 0.6% of GDP, but instead proposed in its original 2019 draft budget an increase of 1.2% according to the Commission. The compromise at zero change was not ideal, Dombrovskis said, but allowed the Commission to drop plans to start disciplinary action that could end up in fines.

Slowdown in UK CPI

British consumer prices rose at an annual rate of 2.3% in November, the lowest since March 2017, in line with market consensus and down from 2.4% in October.

The biggest monthly fall in petrol prices in more than three years was the biggest driver of slower consumer price inflation, reflecting a sharp fall in the cost of a barrel of oil.

British consumers have been pressured by inflation since June 2016's Brexit referendum triggered a fall in sterling. A year ago, inflation peaked at a five-year high of 3.1%.

But despite the fall in inflation since, and a pick-up in headline wage growth to its highest in a decade, businesses have reported a downturn in consumer spending in recent months.

The British Chambers of Commerce forecast on Tuesday that economic growth this year and next would be the slowest since the country was last in recession in 2009.

Earlier this month the Bank of England sketched out a worst-case no-deal Brexit scenario in which sterling would plunge to parity against the U.S. dollar, inflation would exceed 6% and the economy contract by 8%.

Fed to raise rates and lower rate projections

The Fed will likely raise its target rate by another 25bp to a range of 2.25-2.50% today. This would be the fourth hike this year, the most since 2006. The interest paid on excess reserves, IOER, will most likely be raised by only 20bp in order to bring the effective fed funds rate back to the middle of the target band.

The updated Summary of Economic Projections should show similar economic and inflation projections for the coming three years to those forecast in September. The FOMC members’ rate projections, however, will likely be lowered and indicate a shallower path than before. In particular, we expect the dots to signal only two hikes for 2019 (down from three), and the dots for 2020/2021 might each come down by 25bp as well. The main reasons for the more cautious rate outlook are, in our view, tighter financial conditions as well as concerns about the outlook.

U.S. President Donald Trump has repeatedly berated the Fed and on Tuesday said in a Tweet it was "incredible" for the central bank to even consider tightening given global economic uncertainties.

Comments by Fed Chairman Jerome Powell in late November that the key interest rate was “just below” neutral, a level that neither brakes nor boosts the economy, have bolstered investor expectations that U.S. central bank is nearing a pause on its monetary tightening.

The Ifo index in December declined strongly to 101.0 from 102. It was the fourth consecutive monthly decrease and the lowest level since September 2016. Especially the business expectations component deteriorated further to 97.3 from 98.7. The current assessment reading also declined to 104.7 from 105.5.

There is no denying in that the latest business sentiment indicators were worse than expected. The forward-looking business expectations component, our favorite early-bird indicator, declined strongly for the fifth month in a row and hit its lowest level in four years. Especially the export-dependent manufacturing sector took a heavy knock. At year-end 2018, the number of pessimists among business managers was larger than the number of optimists.

Given the latest deterioration, it is important to remain level-headed. To be sure, one should track sentiment indicators closely these days, since both economic and political risks have been rising. However, we think that special circumstances still argue for a rebound in the German economy anytime soon. More important, fundamentals speak against a doom and gloom scenario in 2019. While the signs of weaker momentum are obvious, one should keep a sense of proportion. GDP growth of at least 1.5% next year still seems feasible.

After shrinking economic activity in the third quarter of 2018, many investors have been discussing recession risks. The latest Ifo figures are certainly grist to the mill of growth pessimists. However, as being said previously, we think that the likelihood for a second consecutive quarter in which the German economy shifts into reverse gear is low.

Industrial production in October disappointed. However, this does not call the rebound itself into question. It just needs more time to unfold, as underlying momentum has started building. New orders in the auto sector were nearly 5% above the level in the third quarter. By the way, the latest Ifo business sentiment data for car manufacturers in December also showed a rebound. Business expectations even hit their highest level since the start of 2018.

It is reasonable to assume that private consumer expenditures will continue to grow solidly in the light of sound fundamentals as a further recovery on the labor market and significant wage hikes. Just to give two (backward-looking) figures for the first three quarters of 2018: about 350k jobs liable to social security contributions were created; wages increased by nearly 3% yoy.

What is more, we think that the boom in the construction sector will continue. Despite the recent ramping up of production activities, there is still huge excess demand for houses and condominiums from previous years. The upswing will therefore run its course further.

Fiscal policy should support GDP growth. According to a recent estimate of the German Council of Economic Experts, the growth impulse from fiscal policy could be up to 0.5pp in 2019. Huge fiscal surpluses, the need to spend more money and political considerations among policymakers in the grand coalition play an important role. 2019 is likely to see a paradigm shift in German fiscal policy, a largely underestimated pattern.

The bottom line is that one should not get too pessimistic. While the risks to exports, and hence also to capex spending, are undeniable, domestic demand will keep the economy afloat.

This week, the Federal Reserve will end its eighth and final regular FOMC meeting of the year. It is widely expected that the committee will raise the target range for the federal funds rate by another 25bp to 2.25-2.50%. This would be the fourth rate hike this year, and the total increase of 100bp is the largest annual rise in the short-term interest rate since 2006. At the same time, the interest on excess reserves, IOER, will likely be raised by only 20bp. The goal of this technical adjustment is to bring the effective fed funds target rate back to the middle of the target band. The same tweak was used in June.

More important than the actual rate hike is the outlook for the coming years. The updated Summary of Economic Projections is likely to show very similar economic forecasts as in September. These include GDP growth gradually slowing from around 3% in 2018 to 2.5% in 2019 and towards potential growth of 1.8% in 2021. The jobless rate is likely seen as hovering between 3.5% and 3.75% throughout the forecast horizon, while inflation rates remain close but slightly above the 2% target. Moreover, the post-meeting statement should reiterate that “risks to the economic outlook appear roughly balanced”.

We also expect the statement to reiterate that “further gradual increases in the target range for the federal funds rate will be consistent with sustained expansions of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2% objective over the medium term.” The FOMC members’ interest rate projections (the “dots”), however, are likely to reveal that the pace of these gradual hikes is slower than the committee previously thought. In particular, we expect the dots to show only two hikes for 2019 (down from three), which brings the Fed’s median view in line with our forecast. What happens to the forecasts for 2020 and 2021 critically depends on changes to the longer-run neutral forecast of the fed funds rate. Following recent remarks by senior FOMC members, notably Fed Chair Jerome Powell at the Economic Club of New York, we think it is most likely (though not a foregone conclusion) that the median estimate for the longer-run fed funds rate will come down from 3% to 2.9% or even to 2.75%. If that is correct, the dots for 2020 and 2021 will each come down by 25bp as well, which essentially lowers the entire “dots-curve” by one rate hike. If the estimate for the longer-run rate remains unchanged, the dot for year-end 2021 will remain unchanged, but it would take the FOMC a bit longer to get there, with the hikes being more gradual, rather than occurring in 2019 and 2020.

In our view, there are two reasons for the Fed to sound more cautious on rates, while maintaining its economic outlook. First, concerns over the stock market, and second, the fact that there are greater risks to the outlook than the committee would like to admit at this point. If this is the case, the forecasts and balance of risk are only unchanged on paper.

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