(originally published on February 9, 2008)
The party is certainly over in the US. But the question that has lingered is whether the rest of the world would hang around for a few more drinks. This week gave us further confirmation to firmly rebutt the 'decoupling' hypothesis.
The Bank of England finally acceded to the markets' wishes, cutting its benchmark interest rates by 25 bps this week, following a similar cut in December in response to slowing consumer spending and the steepest decline in house prices in over a decade. BoE has been trying to balance the serious risks to economic growth against the threat that inflation may become entrenched above its 2% target. House prices slid for a third month in January, the longest stretch of declines since 2000. UK mortgage approvals fell in December to its lowest since at least 1999. Retail sales fell the most in 11 months, while manufacturing declined for a second month in December. To complicate matters, inflation is expected to reach its quickest pace in a decade this year driven by surging energy and food costs. The UK economy has expanded every quarter for the past 16 years. Billionaire investor George Soros, not exactly a friend of the BoE, commented last month that a recession in the US was 'almost inevitable' and would be 'very difficult to avoid' in Britain. Consensus expectations are for a further 75 bps interest rate cuts by year-end.
On a similar note, the ECB President Jean-Claude Trichet reversed course and signaled his willingness to cut rates for the first time in five years as economic growth falters. Trichet had earlier threatened raising rates to quell inflation, hoping that growth in emerging markets such as China and India would cushion the effect of a US slowdown. Globally, private-sector business activity contracted sharply in January driven by the huge drop in US non-manufacturing activity as well as contraction in three of the Euro zone's four largest economies - Germany, Italy and Spain. JP Morgan's Global Total Output Index plunged to 47.7 in January, the lowest since the months after 9/11, down significantly from the 53.8 reading in December. Retail sales in the EU region are reported to have fallen the most since 1995.
The Fed has led the way in this crisis by metamorphosing from an inflation-fighter to an economic savior. The BoE followed suit and now the ECB has finally turned over (albeit later than one would have hoped). While the Fed has indicated its seriousness in getting ahead of the curve, the BoE and ECB have remained largely oblivious of the looming dark clouds thus far. The longer the ECB waits in cutting rates, the worse the possible outcome for the Euro zone. The stronger dollar, with the Fed finally looking serious of getting ahead of the curve, and the weaker Euro reflect just that.
The Euro posted its biggest weekly decline against the dollar since June 2006 on speculation of interest rate cuts soon by the ECB. Since investors now know that the US is not the only ship taking on water - and since it is still the biggest and safest ship - it could well be time to climb aboard the dollar!
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