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Ulster Bank Quarterly Focus on Markets - US Economy to avoid Recession, ECB Rate Cuts unlikely, Euro to hit new record highs vs Dollar and Sterling

The following is a summary of the Ulster Bank Quarterly Focus on Markets, which was prepared by Simon Barry Senior Economist, Ulster Bank Capital Markets and published today.

US Economy to Avoid Recession

US services sector to continue to provide important offset to housing and manufacturing weakness; large-scale monetary and fiscal stimulus also supportive

ECB Rate Cuts Unlikely

Record inflation overshoot an obstacle to lower interest rates in the Eurozone

Euro to hit new record highs vs. dollar and sterling

Recent huge moves highlight how critical it is for firms to actively manage currency exposure

  • Recent indicators on US manufacturing, construction and jobs have raised concerns about a US recession
  • Growth will be weak in the first half of this year
  • Activity in the services sector (80% of the economy) is holding up well
  • While risks have risen the bank expects the US to avoid a recession, as growth prospects receive support from fiscal and monetary stimulus
  • Simon Barry says that the bank expects a 50bps cut at next weekís Fed meeting and a further 50bps by April 2008 which would see official rates bottom at 3.25%
  • Ulster donít think that the Fed will need to cut to below 2.50% as the market currently thinks Growth is slowing in Europe too, but inflation is the ECBís main concern Inflation will average over 2.5% in 2008, the largest overshoot in the ECBís history
  • Lower rates not likely unless growth slows sharply
  • UK housing and services now clearly slowing UK rates have another 50bps to fall, though Ulster doesnít share the marketís expectation for a further 50bps beyond that
  • Lower US, UK rates to see dollar and sterling to fall vs. euro in the next month or two
  • Eur/USD to move to new record of $1.50 with $1.55 a distinct possibility; Eur/Stg to also hit a new high of 76.5p
  • Recent huge moves highlight how critical it is for firms to actively manage currency exposure
  • Ulster's interest rate views mean there is room for both the dollar and sterling to rally back later in the year against the euro, to $1.40 and 73p respectively
  • After big moves of late, the scope for further large falls in long term rates looks limited, so hedging interest rate exposure on debt at current levels looks attractive

The US, Eurozone and UK economies grew very strongly in Q3 of last year. But recent indicators point to slower growth since then and a weaker outlook for the coming year. Despite an easing of year-end tension in money markets, conditions in the financial markets remain strained, highlighted by recent weakness in the equity markets.

In the US recent weak data on the jobs front as well as on the manufacturing and construction sectors has given rise to concerns that the US economy may have already entered recession. Simon Barry says Ulster does not share this view. Activity and jobs growth in the service sector (which accounts for 80% of the economy) remain healthy.

While recession risks have risen, and overall growth will be weak in the first half of í08, Ulster thinks that the US can maintain its impressive resilience to date and avoid recession, helped by 100bps of further rate cuts from the Fed (including a 50bps move next week) and a package of fiscal stimulus. Market expectations for rates to be cut by more than 175bps from current levels look excessive to us.

Eurozone growth is also set to weaken, with sub-trend growth of around 1.7% on the cards this year. However, inflation concerns remain the key issue for the ECB, with inflation set to average in excess of its target of close to but below 2% for the ninth consecutive year in í08. In fact it will likely average over 2.5% this year Ė the biggest overshoot in the ECBís history. Slightly sub-trend growth may not be enough to get the ECB to abandon its inflation concerns, though if growth weakened very sharply a cut later in the year is possible

The UK housing market and services sector have weakened considerably of late and the Bank of England cut UK rates in December. Rates there still look too high for a weakening economy, so the bank pencils in another 50bps of cuts in coming months, though with a number of inflation risks on the horizon, it doesnít share the marketís expectation for around 100bps of more easing.

On the fx markets, rate cuts from the Fed and Bank of England mean the dollar and sterling are likely to remain under pressure in the next couple of months, with the euro having hit record highs against both currencies of late. Ulster targets a new high of $1.50 and maybe even $1.55 for Eur/USD by the end of Q1 while Eur/Stg is also likely to hit a new high of 76.5p. But rate cut expectations in both the US and UK look overly aggressive in Ulster's view, so there is scope for both the dollar and sterling to rally back later in the year against the euro, to $1.40 and 73p respectively. The huge moves in fx markets in recent months underscore just how vital it is to have an active approach to currency risk management.

Long-term borrowing costs have fallen very sharply in the US and UK, and have also declined lately in the Eurozone. Ulster thinks the scope for further large declines is limited, so while downward pressure may persist in the short term and it expects long-term rates to be on the rise as we progress through the year. Current levels therefore look attractive from a hedging perspective, especially given stubbornly high short-term variable rates related to the ongoing strains in the money markets.

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