Interest & Exchange Rate Forecast

14 November 2011

RBS Group Economics

Interest Rates
UNITED KINGDOM: After last months 75bn quantitative easing (QE) surprise, it was back to business as usual at the Bank of England in November. The Monetary Policy Committee (MPC) opted for no further stimulus and left the Bank rate unchanged at 0.5%. But MPC members undoubtedly remain on a heightened sense of alert regarding the economic outlook. Q3 GDP growth staged a rebound from a poor Q2, but this masks the underlying weakness in the UK economy, which grew just 0.5% over the last year. With the MPC expecting Q4 growth close to zero and inflation undershooting the 2% target in the medium term, further QE is likely in the near term. Another 50bn is likely in early 2012, probably in February. But if the outlook continues to remain bleak thereafter, the debate could well turn to whether the MPC will persist with further QE or look to alternative unconventional measures to stimulate the economy. UNITED STATES: The Federal Open Market Committee (FOMC) left policy unchanged this month. Although Q3 output grew by a better than expected 2.5% on an annualised basis, the Committee downgraded its 2012 growth forecast for the US economy to 2.7%, from 3.5% in June. At that rate, unemployment would fall only slowly, edging down to 8.6% by the end of 2012, compared to the current rate of 9%. In his press conference, Chairman Bernanke made it clear that he was not satisfied with the unemployment rate but that he had to weigh up the potential costs of further action. In the case of quantitative easing, this would possibly mean stoking inflation. Headline CPI inflation hit 3.9%y/y in September (excluding food and energy costs, core inflation remained at 2%). Even the Feds preferred measure, personal consumption expenditure (PCE) inflation, is heading towards 3%. However, with unemployment expected to remain high, the Fed expects inflation to ease. The latest forecasts show that PCE inflation is expected to fall to 1.7% by the end of 2012, reflecting weakness of domestic demand. Against that backdrop, there is no reason to doubt the Feds guidance that it expects interest rates to stay where they are until at least mid 2013. EUROZONE: The European Central Bank (ECB) cut its policy rate by 25bps to 1.25% at its November meeting, the first chaired by new ECB President, Mario Draghi. Despite inflation sitting at 3%y/y, uncomfortably above the ECBs target, the decision to cut rates comes amid increasing signs of economic weakness. Indeed, President Draghi noted that the Eurozone was heading towards a mild recession by the end of the year. With the ECB likely to revise down its 2012 growth forecast, we expect an additional 25bps rate cut in December. The policy rate has never been below 1%. It seems the ECB prefers to use this level as an interest rate floor, and employ liquidity operations to push market rates lower. Though this doesnt rule out rates below 1%, it does dispel the notion that the ECB has still lots of spare ammunition to fight a recession. At the end of October, European policymakers reached a three pronged deal to shore up Greece: consisting of a 50% haircut on Greek debt held by the private sector; leveraging the European Financial Stability Facility (EFSF) to 1trn; and bank recapitalisation. But times are changing fast. This deal was quickly overshadowed by political crisis in Greece which now has a new Prime Minister and coalition government. Their first test will be to implement the austerity plan necessary to receive the next 8bn tranche of the first 130bn bailout funds. As if this wasnt enough for the poor Eurozones heart, Italy failed to convince markets of its ability to deliver reforms necessary to put the country on a sustainable debt path. This sent Italian 10yr bond yields above 7%, a point beyond which Greece, Ireland and Portugal required bailouts. Interest Rate Forecast (%)
Source: Thomson Datastream, RBS Group Economics

Exchange Rate Outlook

Source: Thomson Datastream, RBS Group Economics

6.0 5.0 4.0 3.0 2.0 1.0 0.0 2008 2009

Euro Refi Rate US Funds Rate UK Bank Rate

Forecast

2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3

2014

$ per (LHS)

Euro per (RHS)

1.30 1.25 1.20 1.15 1.10

Forecast 2008 2009 2010 2011 2012 2013 2014

1.05 1.00

2010

2011

2012

2013

Contact: David Fenton Group Economics +44 131 626 3701 david.fenton@rbs.co.uk

www.rbs.com

Interest & Exchange Rate Forecast

EUROZONE (CONT): The resignation of Prime Minister Silvio Berlusconi and introduction of a technocratic government led by Mario Monti, an economist and former European Union Commissioner, has helped restore some confidence to markets. Coupled with intervention by the ECB (which increased its purchases of Italian bonds), 10yr bond yields have dropped to around 6.6%. But significant challenges remain for Italy and the Eurozone. The drama continues.

Exchange Rates
The Eurozone debt crisis has dominated markets over the past month with exchange rates highly correlated with swings in equity indices. This trend has been so pronounced that the ECB interest rate cut had only a minimal impact on the euro. The single currency staged a fight back in October as politicians attempted to thrash out a solution to the crisis. Optimism peaked after the EU summit with EUR/USD up to 1.42 and GBP/EUR down to 1.14. The rally has been largely reversed on the political strife in Greece and Italy, and these themes are likely to continue. Good news from the Eurozone could prove euro positive in the short term, but the underlying failure to find a comprehensive solution remains a clear obstacle. We expect this to translate into further euro weakness, with the dollar in pole position to gain from safe haven flows. Sterling has regained much of Septembers lost ground against the dollar, with GBP/USD pushing back towards the 1.60 level. This cross has broadly remained within a narrow range of 1.55-1.65 over the past year. An attempt to make a break lower in September was rebuffed, with GBP/USD unable to breach support around 1.53. But further global weakness or Eurozone contagion could see more tests on the downside. The Japanese Government intervened again to weaken the yen (another safe haven currency), which had strengthened to c.75 against the dollar. This latest bout of action has pushed the USD/JPY cross up to 78. Japanese authorities are clearly sensitive to levels around the mid-70s. RBS Group Economics Interest and Exchange Rate Forecasts EXCHANGE RATES (end of period) $ per 2011 Q1 Q2 Q3 Q4 2012 Q1 Q2 Q3 Q4 2013 Q1 Q2 Q3 Q4 2014 Q1 Q2 Q3 Q4 1.60 1.61 1.56 1.54 1.51 1.51 1.52 1.53 1.54 1.55 1.56 1.57 1.58 1.59 1.60 1.60 $ per 1.42 1.45 1.34 1.32 1.28 1.27 1.27 1.27 1.28 1.29 1.29 1.29 1.29 1.29 1.29 1.29 per 1.13 1.11 1.15 1.17 1.18 1.19 1.19 1.20 1.20 1.20 1.21 1.23 1.23 1.24 1.24 1.25 per $ 83 81 77 76 76 76 77 78 80 82 84 86 88 90 92 94 INTEREST RATES (%, end of period) Euro Refi Rate 1.00 1.25 1.50 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.25 1.25 1.50 1.75 2.00 2.25 US Funds Rate 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.50 0.75 1.00 1.25 UK Bank Rate 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.75 0.75 1.00 1.25 1.50 1.75

Key Central Bank monetary policy meetings for the remainder of 2011 and the beginning 2012 Bank of England US Federal Reserve European Central Bank 08 Dec, 12 Jan 2012, 09 Feb, 08 Mar, 05 Apr, 10 May 13 Dec, 25 Jan 2012, 13 Mar, 25 Apr, 20 Jun, 31 Jul 08 Dec, 12 Jan 2012, 09 Feb, 08 Mar, 04 Apr, 03 May

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