THE ECONOMIC STORYTHIS WEEK IN BRIEF: March 19 - March 23, 2012 (Written Friday, March 16, 2012. The Economic Story is normally updated every Friday evening by Decision Economics, and revised if events cause a significant change in the economic outlook or in the risk profile.) GLOBAL MARKETS WEEKLY Bond Bloodbath: Is Everybody Bleeding? The jump in U.S. Treasury yields in the past week has not been an isolated event. Yields in Germany and the U.K., for example had risen sharply as well. While each country has its own specific story, investors generally perceive a better (or at least not worse) economic tone together with a sense that pace of increase in central bank liquidity provision may have peaked. An obvious erosion of the safe haven bid has played an important part. Still, there are reasons to think that investors have overreacted. In the U.S., investors who had banked on QE3 unfolding in Q2 are folding their tent in the face of stronger economic news and little encouragement from the Fed. But to then starting to price-in a tightening by year-end seems far fetched. The Fed just extended the low for long interest rate pledge from mid-2013 to the end of 2014! Furthermore, we still worry that Q1 GDP growth will print less than 2%. If that happens in late April, will investors clamor for QE3 in Q3 to save them? Or if housing falters because of the backup in interest rates, will Bernanke come to the rescue, even if the labor market continues to firm? In the U.K., the BoE seems less downbeat, suggesting that the more positive economic news has been the main factor behind the rise in gilt yields. This reduces the chances of further asset purchases, even though we think the recent patch of economic news has been no better than mixed. In Germany, the focus has been on the strength in the manufacturing surveys, even though household spending appears weak. The relative optimism of the ECB about the success of recent liquidity measures (and implicitly that the recession would be mild) and talk from the Bundesbank about policy exiting gave investors further reasons to sell bunds. (Eurozone politics is the focus article this week). However, interest rates in peripheral nations like Spain have not risen, as investors remain worried the growth prospects of the peripheral nations and for the Eurozone as a whole. In short, while we think interest rates will be higher over the next year as global recovery continues, interest rates do not rise in a straight line. U.S.: Views about how "real" the recovery really is are unlikely to be tested this week, as the few indicators on housing will continue to point to a sector treading water. Bernanke's utterances this week will be uninformative, although a research confab of central bankers at the Fed over the weekend may provide clues on how they think about QE3/QE2/QE1 and all the other emergency actions they undertook since 2007. Eurozone: The high profile flash PMI should improve after the mixed message from last month. But the theme of continued if not deeper weakness outside of Germany seems likely. The various consumer surveys including the flash Eurozone confidence figure will be watched keenly, given the weakness seen in spending of late.

page 1 of 14

THE ECONOMIC STORY UK: The Chancellor's budget statement will have little meaningful to investors unless it supports speculation of an ultra-long bond. The potential weakness in the upcoming retail sales data may be corroborated by the consumer confidence update. Another decline in the CPI is likely, although less pronounced than in January. The MPC minutes may show a disappearance of the voting split after the more positive data. The question is how much have the downside risks receded. Japan: A credible bottoming in exports in this week's trade report would be surprising at this stage, given concerns about global growth. The all-industry-activity report will combine the good industrial production and poor tertiary industry results with figures for several smaller industries to portray the full output side performance of the economy for January. The comparison with December results (+1.3%) will not be favorable, potentially stunting GDP growth in the quarter. Emerging Markets/Regions: The Bank of Thailand will leave policy unchanged after lowering rates 25 bps to 3.0% in January. After the devastating floods, the bank remains growth supportive. Increased stimulus and higher oil pries pose a future inflationary threat, which the bank thinks could be countered by slower global demand growth. We also focus on India, where monetary easing is coming. Focus on Eurozone Politics Bail-out fund differences persist. Just as the economic tensions through the Eurozone have ebbed and waned in the last months, so have political strains both between and within the countries involved. Notably, however, these political strains remain very clear, with there being every likelihood that they could actually intensify. For a start, the next few weeks will see heated-up debate about the size of firewalls to protect ailing Eurozone bond markets. It is, however, far from certain that the current hope - the current EFSF with its circa-250B of unused resources to be added to the 500B that will be available from the ESM - will be accepted by a still-skeptical Germany, the latter actually wary that any such enlargement would temper the drive for budget cuts. Greece election still a threat. Perhaps the one most worrying to the policy makers that have just cobbled together the bail-out is if Greece sees a near-term election. Given the pattern in opinion polls, such an election could very easily unseat much of the current parliament and, instead, return politicians that would eschew the recent promises that the country has made in order to get that bail-out. If so, these bail-out funds could easily be pulled, leaving Greece facing a more formal default over and beyond the debt swap that it has recently overseen. Such a risk is one reason why the likes of Germany had been pressing for countries with doubtful fiscal records like Greece to have external overseeing of its budgets. Fiscal compact to create more divides. Instead, Germany got its way with the signing of its so-called fiscal compact last month, a set of rules designed to entrench budgetary discipline. However, this fiscal compact may be the very thing that intensifies political differences among Eurozone countries in coming months. Already, it has triggered a spat between the Eurozone and Spain regarding the respect of budget targets: some compromise has been reached, albeit possibly setting a precedent for other countries to demand less onerous fiscal targets regardless of the acrimony

page 2 of 14

THE ECONOMIC STORYthat this could create. Regardless, opposition to austerity is clearer in Spain with a general strike due at the end of the month. Austerity weariness is also emerging even in what have been fiscally hawkish countries such as the Netherlands as its recession bound economy accentuates problems to a degree that may demand budget cuts that could undermine a (minority) government that so far has been very supportive of German thinking. In addition, parliamentary ratification of the fiscal compact may be far from smooth in many countries, including the Netherlands. More notably, Ireland has said it will have to hold a referendum in regard to the fiscal compact, probably in or around June. A positive result is likely but far from guaranteed, the reason why Ireland is 'requesting' a reduction in the cost of bail-out aid it has received for its banking sector, but with the EU so far unyielding. French election: a change at the helm? However, by far and away the most risky political development is the election in France this spring. Opinion polls clearly suggest that incumbent President Sarkozy will be unseated in the second round of elections on May 5 by the Socialist candidate Francois Hollande. Obviously this would be a major political development for France, but such a result could have reverberations throughout the EU, as effectively this election may be an election on the very issue of how the Eurozone runs itself. A referendum on the future of Europe? In particular, presidential candidate Hollande is questioning the very fabric of how Germany (as led by Chancellor Merkel) has decided where the Eurozone future lies, ie the fiscal impact must be at the heart. France (under Sarkozy) has seemingly signed up to this view leading to the coining of Merkozy politics, although it is notable that Sarkozy himself has hinted that he too may opt for a referendum on the fiscal compact if elected. Extent of loss of sovereignty at stake. The Merkozy approach basically implies that if the Eurozone is serious about deeper fiscal and political integration then first must come the transfer of budget sovereignty to supra-national bodies such as the EU. Only once this fiscal discipline is firmly in place would Germany consider greater concession about its fiscal sovereignty. In contrast, Hollande, by saying he would seek to renegotiate the fiscal compact deal, is arguing for more growth orientated policies, a more active ECB and possibly even common bonds. These are largely anathema to Germany, but some of these arguments (eg measures to support growth) are also being aired by other Eurozone leaders such as PM Monti in Italy. In other words, Hollande is pointing to a fiscal union of the kind that the current German government clearly opposes, although possibly being more acceptable to some of the country's opposition parties. In other words, rather than having a one-sided painful adjustment from debtor countries, any move to overall Eurozone sovereign solvency must be more symmetric and include measures to reduce imbalances from creditors, the latter possibly involving taking more risk with inflation. Perhaps implicit in this is the view that there would be no appetite for more entrenched fiscal integration without the lure of common Eurozone bonds, something that would underpin a willingness of all countries to stand behind each other. Germany diverging politically as well as economically? Of course, the current rhetoric from Hollande may be nothing more than electioneering: if he were to win he may be far more amenable to Germany. However, the risk is that a change at the helm in France in coming months could not only unnerve Germany but the likes of the ECB (and particularly the more recently more vocal Bundesbank) where the fiscal compact has been used as

page 3 of 14

THE ECONOMIC STORYthe means that has provided the scope for the central bank's sizeable liquidity actions seen of late. Regardless, coming months may not only continue to see the Germany economy diverge further from the rest of the Eurozone, but perhaps that this may only serve to accentuate German political thinking becoming more isolated. (Andrew Wroblewski) United States IS QE3 Dead? Data/event recap: Is QE3 Dead? The Fed did not change policy nor give a hint that a near term policy change was likely. The FOMC upgraded the economic assessment although they emphasized the downside risks. They played the oil card but only in a way to emphasize its adverse impacts on "subdued" inflation. No mention was made of its potential drag on income and growth, something Bernanke talked about last month. This was not a signal that oil made them nervous (yet) about growth. We may learn from the FOMC minutes available in early April how much interest there was in the various policy options--QE3 or intermediate steps such as sterilizing Treasury purchases to lower long-term rates and changing the composition of the balance sheet to favor mortgages over Treasuries. As we discussed on the front page, this continued lack of encouragement from the Fed has contributed to the backup in interest rates as more investors have given up on QE3 anytime soon. However, QE3 may return to the market mindset, if GDP growth falls well short of Q1 (more on this below) or it the backup in interest rates contributes to a stumble in housing. Stress test not market stressful. The results of the latest Fed stress test helped boost bank stocks and in turn the equity market as a whole last week. Inflation data a mixed bag. Energy prices boosted both the PPI and CPI last month. However, the PPI rose 0.4% less than expected (DE: +0.6%; consensus +0.5%). The core rate was superficially tame at 0.2% in line with expectations but there were some categories in consumer nondurables with outsized increases. And core intermediate prices, a leading barometer of future inflation, rose a whopping 1.0% almost reversing four months of declines. The CPI rose 0.4% as expected (DE: +0.4%; consensus +0.4%) with the core rate at 0.2% (also as expected). Even food prices which had been a tear moderated in January and more so in February. The y/y change was unchanged at 2.9% and the core rate appears stuck at 2.2%, after accelerating from 1% to 2% in the first three quarters of 2011. These updates will not change positions at the Fed, with doves looking for inflation to soften once energy prices have run their course, while hawks are concerning that underlying inflation will grind higher in response to the unfolding expansion. The hawks will also fret about the increase in short-term inflation expectations coming from the rise in gasoline prices seen in March consumer surveys (more below) Brighter Q1 GDP above 2% possible? The retail sales and business inventory reports were stronger than expecting and suggest that GDP growth might top 2%, despite the slow start to spending earlier in the quarter. Retail sales rose 1.1% in February (DE and consensus: +1.0) with upward revsions to the previous months lifting the level of retail sales by 0.5 percentage point. Business inventories rose 0.7% in January, well above expectations (DE: +0.3%; consensus: +0.6), also preceded by upward revsions to late 2011. Higher inventories are a two edged sword, boosting near-term production but risking lower future production if the increase is (or proves) unwanted. Outside of anecdotal reports of high inventories in

page 4 of 14

THE ECONOMIC STORYDetroit, there are few reports that the inventory buildup could prove unwanted. Sentiment: first hint consumers hurt from higher gas prices. Consumer sentiment dropped 1 point to 74.3 in March (DE: 76.5; consensus 75.6) the first signal that higher gasoline prices are starting to bite. In fact, one -year ahead price expectations jumped from 3.3% to 4.0%, the highest since May during the last scare. A sustained drop in over 10 points over a few months would be a warning signal (it dropped 10 points in March 2011) to the Fed. The index steadied for several months however, before falling off a cliff last summer, falling 16 points from June to August. It is now 20 points above the August low. Steady to higher manufacturing. The closely watched but volatile empire state and Philly Fed regional mfg. surveys in March suggested some 2 to 4 point increases in the ISM index from its 52.4 level in the next few months. But industrial production fell short of expectations with no change (DE: +0.5%; consensus: +0.4%) because of declines in mining and utilities. This hid a more comforting above trend 0.3% gain in the mfg sector The week ahead: Housing. Still stuck in neutral? The three housing reports will suggest the sector continues to underperform. With housing effectively going sideways, the current expansion is not experiencing the 0.5 to 0.75 percentage point boost that comes from the housing sector when activity starts jump 25 to 50% in the first year or so. It has taken three years for housing starts to rise one-third above its 2009 low, diminishing its positive impact on GDP growth. Housing starts (Tu) should rise marginally in February from 699K in January (DE: 712K versus 700k). Existing home sales (Wed) may enjoy a moderate gain from 4.57M units in January (DE; 4.62M; consensus 4.60M) with a possibly smaller gain for new home sales (Fri) from 321K in January (DE: 332K; consensus: 325K). Fedspeak: Evaluating what we have done. Bernanke's utterances this week (Tu, Th) will be uninformative, as he speaks to student groups on the role of the Fed. He will also deliver opening remarks (Fri) for a research confab of central bankers at the Fed over the weekend that may provide clues on how they think about QE3/QE2/QE1 and all the other emergency actions they undertook since 2007. Speeches by doves Dudley (always votes, Mon) and Evans (voter 2013, Th) may indicate how much passionate they remain about easing more, while Kocherlakota (voter 2014) will put in his hawkish oar earlier (Tu). Governor Tarullo (always votes, Th) speaks on the Volcker rule to Congress. (M. Cary Leahey) Canada Growth outlook 2012: Auto sales in the driver's seat? Recap: Capacity utilization undershot expectations at 80.5% (Consensus: 81.6%, DE: 82.5%). While capacity utilization is at its highest level in four years and has been edging upward steadily for the last two, declines in non-manufacturing utilization dampened Q4 data. January manufacturing shipments surprised forecasters falling 0.9% m/m (Consensus: +0.2%, DE: +0.8%) for January to C$49.6 billion and bringing the year-on-year increase to 1.9%. This decline, the largest in seven months, was due to a 34% m/m drop in aerospace parts shipments. Auto sales were strong-- motor vehicle sales rose 2.6% m/m and auto parts sales were up 6.2% m/m. Inventories increased 1.1% m/m, bringing the

page 5 of 14

THE ECONOMIC STORYinventory-to-sales ratio to 1.32 months from 1.29. New orders point to an encouraging outlook, up 0.8% for the month.anada is reporting strong auto sales for the beginning of 2012, with January retail sales up 15% from a year ago and now at the highest level since 2008. New motor vehicle sales make up about 20% of total retail sales in Canada, and historically have been a good predictor for the headline index (see Chart 1). Auto and auto parts sales also play a significant role in both Canadian wholesale and manufacturing sales, as well as GDP. This positive trend in auto and auto parts sales is the result of improved supply and improved demand. Supply chains with Japan seem to have finally recovered from last year's tsunami. Moreover, Japanese car companies have stepped up their production levels in North America to try to replenish their depleted inventories. Similar to the U.S., Canada believes its growth will accelerate over the year and cites domestic consumption as the primary driver of growth. In the accelerating growth phase of the business cycle consumer spending behavior, consumer confidence, and the labor market all positively reinforce each other. Consumers who have postponed replacement of durable goods look to do so, and that bump in consumption can kickstart the economy into healthy expansion territory. In addition to consumers, Canadian businesses have also decided they can now replace their company vehicles-business purchases are up 74% over last year. Preliminary evidence suggests that this strong auto trend will continue, albeit at a more sustainable pace, and should contribute positively to U.S. and Canadian growth over the next year. Week Ahead: Wholesale sales (Mon., 8:30 a.m.) may show a boost in sales due to the recent surge in auto activity, while inventories are likely to moderate. Retail sales (Thurs., 8:30 a.m.) should also show strength due to autos as car dealers reported record sales in January; however, we expect growth in ex-auto sales to be significantly more subdued. The CPI and core CPI (Fri., 7:00 a.m.) may show increases as commodity prices continue to recover. The BoC seems set on holding interest rates put while watching the Eurozone recession and U.S. recovery unfold, and Friday's data will likely show well-anchored inflation expectations providing little motivation for the BoC to tighten in the near term. (Melissa Pumphrey)

Eurozone Economy Still in Trouble? Data/event recap: ECB optimism unfounded? Possibly it taking note of the continued slide in measures such as the Euro Libor-OIS spread, it is even clearer that the ECB is happy with the impact of its recent liquidity provisions, Notably (via efforts from the skeptical Bundesbank) it is even thinking openly about how and when it may have to exit such measures and very clearly is suggesting no further major initiatives from the Council should be expected. Moreover, it has even started to flag wariness about inflation (see below). The question is the extent to which this 'optimism' is possibly a result of complacency about the economy, partly a result of German economic solidity giving an overly upbeat picture of Eurozone real

page 6 of 14

THE ECONOMIC STORYactivity. Certainly (mixed) data in the last week helps support such a notion. Indeed, visible trade data showed a further rise in exports. Seasonally adjusted trade data showed a smaller surplus (of 5.9B) January, down from December's 7.4B, as a 1.3% M/M further rise in exports came alongside a recovery in imports. Coming in very much ahead of expectations yet again, in Germany, the March headline ZEW (expectations) index rose for a fourth successive month and (again) clearly so. It climbed a marked 16.9 points to 22.3, the highest since June 2010. Moreover, the latest reading moved further above the long-term average. Industrial production still very weak. Meanwhile, Eurozone industrial production rose afresh in January, edging up 0.2% M/M, albeit making little inroad into the 1.1% M/M December drop, the latter having been the second fall in the three months since slump seen in September. Notably, there was also generally no worse news regarding output in the peripheral economies, with actually clearly less bleak numbers in Portugal and Greece. However, subsequent data reminded that output weakness is becoming more apparent elsewhere in the Eurozone, such as the Netherlands. Employment drops further. Furthermore, the more disparate nature of the Eurozone economy was evident in the latest payroll numbers, where employment dropped 0.2% in Q/Q terms in Q4, matching the revised fall of the previous quarter, the latter having the first fall since the end of the 2009. As a result, the Y/Y rate in Q4 turned negative falling 0.2%. The partially available break-down showed that the latest Q/Q drop was more broadly based across sectors than in Q3. Inflation stable, core rates low. Seeing no revision from the flash numbers, final February data saw HICP inflation remain at 2.7% Y/Y, matching the upwardly revised January reading. The breakdown released for the first time with this update showed that the resilience in headline inflation was very much based around the impact of energy. Indeed, core rates were much lower than the headline, and also unchanged, with narrowest measure (which excludes energy, food, tobacco and alcohol) stuck at a five-month low of 1.5% Y/Y, while the core measure more favored by the ECB (where only energy and unprocessed foods are excluded) remained at 1.9%. The ECB has clearly become more wary about inflation, not only no longer pointing to lower wage, cost and price pressures that characterized its thinking in late 2011, but now even starting to mention the need to avoid second-round effects, ie the kind of rhetoric used in the run-up to the hikes seen in the first half of 2011 The week ahead: Surveys to show more divergences? Given the divergences still evident in the Eurozone economy, the surveys updates this week take on continued interest, both to see if the overall activity is picking up or not but also where any such improved momentum may be coming from. Most interest, of course, will be in the high-profile flash PMI data due on Thursday. Last time around, the PMIs suggested that Eurozone economic activity was at best stabilizing into the current quarter but may have contracted afresh. Indeed, the aggregate PMI reading for the Eurozone softened

page 7 of 14

THE ECONOMIC STORYfor the first time in four months, actually slipping slightly to levels marginally consistent with contracting activity for the whole Eurozone and to a more clear-cut fall outside of France and Germany. Even so, the survey carried mixed messages, as the manufacturing PMI (Consensus: 49.5; DE: 50.0) rose for the third month in succession, while the services PMI (Consensus: 50.3; DE: 49.3) slid from a five-month high. Better outcomes are expected this time around, with the manufacturing number responding to the improved global backdrop, while the services counterpart may recover from a February reading adversely affected by weather. However, the theme is still likely to be of continued, if not deeper, weakness outside of Germany. Consumer surveys to improve? However, over and beyond the business surveys updates which will also be forthcoming in the likes of the French INSEE survey (Fri) will be the various consumer survey signals. These are all the more important given the clear, if not clearer consumer weakness that has been evident of late, even in vanguard countries such as Germany. In this regard, the flash Eurozone consumer confidence number (Thu) may be watched with more keenness than usual, especially after the two modest pick-ups seen in the last sets of numbers. A further rise is anticipated, but may not signal much in terms of its impact on consumer spending: recent ECB research notes that confidence measures may not be a particularly accurate guide to contemporaneous consumer spending developments, noting that the correlation varies across countries and over different time periods. (Andrew Wroblewski) United Kingdom Fiscal Backdrop to the Fore Data/event recap: BoE less downbeat? The better data trend of late was acknowledged by the BoE more notably in the last week, suggesting that the more positive economic news was the main factor behind the rise in gilt yields seen of late, albeit these comments (from MPC member Broadbent) clearly implying no predilection from himself towards more asset purchases. Even so, the latest batches of economic data were no better than mixed. Employment growth softens. Claimant count unemployment rose by more than most expected, albeit not significantly so, with it notable that the increase of 7 200 M/M in February was similar to that of the previous month and was still modest by the standards of the rises seen over the last year. On a further ambiguous note, the (broader) ILO measure of unemployment saw an increase of 28 000 in the three months to January, continuing the trend towards smaller rises seen in previous months but keeping the jobless rate at a cycle-high of 8.4% On a more downbeat note, the rate of redundancies (again) rose a little further. Less upbeat, employment rose but less much strongly than in the previous update, hardly rising at all in the quarter to January, albeit a weaker outcome mainly due to a fall in self-employment. Regardless, what work there was is still dominated by (possibly far from voluntary) part-time working, albeit with the data suggesting that the private sector has, indeed, helped offset the impact of falling public sector payrolls. Earnings growth softens. Average weekly earnings growth dropped clearly to 1.4% Y/Y in the three months to January, this occurring partly as a

page 8 of 14

THE ECONOMIC STORYresult of a marked drop in the single month Y/Y figure (to a 21-month low of just 0.7%). These weaker numbers were affected only modestly by bonus pay effects as regular pay earnings were also down sharply at 1.1% for the single month of January. This is another set of mixed messages regarding the labor market, albeit echoing the less downbeat messages in labor market survey data seen of late. Regardless, what work is being garnered is still being remunerated softly and still clearly below what is now falling consumer or retail price inflation rates. Indeed, the latest (and actually much weaker) earnings data, in tandem with increased signs that what work there is far from full-time (self-employment remains near an all-time high), actually implies even more erosion may be occurring in regard to household spending power. Mixed housing market continues. The latest (February) Royal Institute of Chartered Surveyors house price survey highlighted a moderately less negative price picture at the national level, although significant divergences at the regional level was still evident. Exports still strong. On a more unambiguously positive note, while the total visible trade gap widened from an upwardly-revised gap of 7.18B in December to a deficit of 7.53B in January, the data showed that exports rose 2.0% M/M in January, led by cars and oil, thereby accentuating the jump of 4.1% Q/Q through Q4. The week ahead: Media wise, the main event of the week will be the 2012 Budget Statement from Chancellor Osborne on Wednesday. This is unlikely to have any meaningful impact on the markets, although gilts will be interested to see if the press releases released alongside the main Budget material corroborate recent speculation regarding the launch of an ultra long bond (ie up to 100 years). Otherwise, any policy measures in the Budget are going to be very revenue neutral, with the Chancellor Osborne stressing that the latest threat to the UK's triple AAA status (announced this week by Fitch) underline (at least from his perspective) the need for continued budget austerity. In this regard, Chancellor Osborne is likely to blame any downgradings he will unveil to the growth picture as a result of reverberation from the Eurozone, ignoring the likely impact of domestic budget cuts on the UK consumer in particular. Regardless, just hours before the formal Budget presentation, comes the monthly update into Government finances. Last time around, (January) public sector finance data saw the budget backdrop improve somewhat further, still a reflection of control on spending and relatively strong receipt growth. The good news is that, despite the under-performance of the real economy this year, borrowing is actually falling and on track to meet if not undershoot targets. Alongside the impact of spending cuts, this is seemingly a result of the strength in the nominal economy as opposed to the flatness in real activity, the former helping to bolster revenues. Retail sales data (Thu) may show fresh signs of consumer weakness (Consensus: 0.6% M/M; DE: -0.5%), with softness that may be corroborated in consumer confidence data on Friday. Further fall in inflation beckons. CPI data (Tue) should show a further drop in the headline rate, despite the impact of rising fuel prices seen in the last few weeks. The drop should be far less marked (Consensus: 3.3% Y/Y; DE: 3.5%) than in the January numbers, where indirect tax-related bases effects caused inflation to fall clearly to a 15-month low, dropping another 0.6 percentage point to 3.6% Y/Y, also down further from the September three-year high (of 5.2%). More on the MPC. Minutes to this month's MPC meeting arrive on Wednesday, but may not enlighten markets with much added insight into BoE thinking. The voting split seen in the February meeting may have disappeared, albeit with the committee clearly embracing the better data picture

page 9 of 14

THE ECONOMIC STORYseen of late. The question is the extent to which the continued downside risks are still very much envisaged. (Andrew Wroblewski) Other Europe Sweden: Labor Market Still Flat Data/event recap: CPI and jobless data offered no further insights, still showing below-target inflation and a stalling labor market. The week ahead: The coming week has no data of any note Norway: Policy Eased Again Data/event recap: Surprising most, the Norges Bank reduced its key policy rate by 25 bps to 1.50% after its latest Board meeting, thereby adding to the equally unexpected but larger 50 bps reduction made the last time in December. The new rate is the lowest since October 2009 when the last tightening cycle began. The December cut was largely explained by the need to be very pro-active against the barrage of downside risks the Bank then saw, albeit with it at least implicit that the easing then was more to do with the seeming obsession of Norges Bank, namely to prevent any clear rise in the Krone. At least this time around, the Board is being more open, explicitly pointing to the strong Krone as a justification via its perceived impact on both inflation and real activity. However, while the accompanying updated Monetary Policy Report (MPR) highlighted that inflation is now expected to remain below target until 2014, it still pointed to clearly strong growth ahead with mainland GDP (excluding the rampant petroleum sector) hardly revised lower and therefore still seen likely to enjoy growth of 3% going forward. The Norges Bank may argue that this is merely trend-type growth, but this would leave the economy with no output gap from this year onwards. Such numbers clearly explain why the MPR pointed to no further cuts, as does the continued growth in debt levels in the country. Even so, the sharp drop in exports that undermined GDP growth to some degree last quarter may have been instrumental in turning the more explicit softer Krone rhetoric seen from the Norges Bank so far this year into further action, despite the resilience in growth domestically and the easing in financial market tensions which it duly acknowledged. The question is will this rate reduction be any more successful than the December move in holding down the currency. Probably not: markets are focusing on the very resilience of the Norwegian economy as one factor for interest in the Krone. In addition, with the Norges Bank advertising that further rates cuts are not being envisaged and even acknowledging the possibility of having to tighten, Norwegian official rates will therefore remain at the top of the range of rates offered by major industrial countries. Regardless, the other question is the extent to which FX markets will see this Norges bank action as a further example of 'currency wars'. The week ahead: More signs of economic resilience may be evident in labor market numbers on Wednesday, albeit with market eyes directed more towards the exchange rate backdrop.

page 10 of 14

THE ECONOMIC STORYSwitzerland: SNB Little Nothing New to Report Data/event recap: Surprising none, the SNB reiterated in its latest quarterly policy assessment enforcing the minimum exchange rate of SFr 1.20 per euro originally set on September 6. Once again underscoring that it is prepared to buy foreign currency in unlimited quantities. It continues to aim for a three-month Libor at zero to 0.25%. Unlike the run-up to the last meeting (in December), there had been little speculation this time around that the SNB would opt to rein in the franc even more, possibly by shifting its exchange rate target to around SFr 1.25 per euro (ie a weaker franc). Obviously this was not forthcoming despite the fact that the SNB inflation forecast once again being adjusted downwards. Indeed, the SNB now sees inflation staying negative for the whole of this year, turning positive a quarter later than envisaged back in December owing to the effects of the earlier currency appreciation, which the SNB has had a stronger dampening impact on prices than previously expected. The forecast 2012 therefore now sees the SNB expecting a drop in prices of 0.6% and for 2013 a return to inflation of 0.3%, the latter doubling in 2014. However, these forecasts are, on balance, little changed from the December assessment. This softer near-term inflation picture comes in spite of a more resilient economic outlook, with the projection for GDP growth this year doubling to close to 1% compared to that envisaged three months ago. This clearly underscores the resilience that actual data has shown in regard to Swiss real economy and financial developments, something that has persuaded the clearly dovish central bank to accept implicitly that downside risks may have diminished. There is little of note in the latest SNB update, partly a result, no doubt, that the Board is still in a state of disarray after the resignation of President Hildebrand in January, with the efforts of interim President Jordan undermined both by recent investigations of the Board's personal trading activities. Regardless, there is clear pointer that further action could be forthcoming from the SNB. However, rather than this being forthcoming if the Swiss franc does not weaken further, the central bank may be content to avoid any fresh appreciation, ie reluctant to risk having to turn what has been very successive rhetoric in curbing the currency into actual intervention. The week ahead: Industrial production (Tue) may show continued weakness, but money supply (Wed) data may be strong, the latter highlighting the resilience in the Swiss financial system. (Andrew Wroblewski) Oceania Australia: Confidence Deteriorates Data/event recap: The past week was relatively quiet in terms of economic data, albeit starting on a downbeat note with home loan approvals and NAB business confidence data. Specifically, the former fell for the first time in ten months, dragged down by ex-refinancing approvals, while the latter dropped to the lowest since September 2011. Elsewhere, consumer confidence numbers compiled by Westpac continued the downbeat tone

page 11 of 14

THE ECONOMIC STORYwith the first drop in consumer sentiment since December 2011 and Q4 dwelling starts figures completed the week with the sharpest drop seen in five quarters. The week ahead: The coming week kicks off with Leading Indexes compiled by the Conference Board (Tue) and Westpac (Wed) respectively. The only other notable release of the week are the minutes to the Reserve Bank of Australia policy meeting (Tue) on 6 March, where little additional insight is expected beyond the information provided in the statement from Governor Stevens following the meeting. New Zealand: GDP Data Awaited Data/event recap: The sole notable data release of the past week was the Performance of Manufacturing Index for February. This showed a jump to a fresh cycle-high, now implying much faster expansion in the sector and reflected clear improvements in both production and new orders. The week ahead: The coming week begins with survey updates in the form of Westpac consumer confidence numbers for Q1 and the Performance of Services Index (both Mon). This is followed by current account data for the fourth quarter on Wednesday, where expectations are for the current account deficit to narrow clearly from the previous quarter. All of the attention next week, however, will be turned to GDP data for Q4 arriving on Thursday. Market expectations are generally for a slight slowing in the Q/Q rate of growth, albeit with the Y/Y pace projected to pick up, in line with RBNZ forecasts made earlier this month. (Chang Liu) Japan Trade report in focus Data/event recap: Key data of the week were somewhat mixed. There was a less-than positive direct indication on output coming from January tertiary industry activity results, showing service-sector activity down 1.7% from December-fully offsetting the 1.8% December gain, and starting the new quarter off weakly. There was also a poor indication on business sentiment coming in the first-quarter Ministry of Finance Business Outlook Survey, which showed deterioration from the fourth quarter across companies of all surveyed size classes, as against predictions of meaningful improvement made in the last Survey. However, better news on sentiment came in January machinery orders, with showed a 3.4% rise-hinting that the recent multi-month phase of extraordinary volatility in demand has centered around a mild, but still upward, trend-while January manufacturing-sector health was confirmed by revised industrial production data, showing a revision down only to +1.9% from the preliminary +2.0% estimate. Bank of Japan policymakers, meanwhile, eased their stance a very modest notch further at the regular monthly Monetary Policy Board meeting, leaving rates and its financial asset buying program unaltered, but adding 500 billion to a program supporting bank lending to growth sectors of the

page 12 of 14

THE ECONOMIC STORYeconomy, and expanding the program by a further 500 billion with a special fund for "small-lot investments and loans that had not been deemed eligible in the main rules of the program," and by a yet further 1 trillion in funds to support "investments and loans denominated in foreign currencies." The latter would be financed from the BOJs existing U.S. dollar reserves, keeping the balance sheet impact neutral. There was also a modest upgrading to the Policy Board's economic assessment, with the former characterization that "economic activity has remained more or less flat" now augmented by the additional phrase "although it has shown some signs of picking up." The Noda Government made a high-profile reiteration of its view that the yen is overvalued, with PM Noda saying in parliament "Compared to record highs seen last October the yen has weakened but as a trend it is still somewhat overvaluedthe yen is valued highly in relative terms when considering fundamentals." Finance Minister Azumi, for his part, kept the specter of intervention fresh, repeating his pledge to "take firm action against excessive and speculative moves in currency markets." The week ahead: Trade report in focus. The holiday week ahead brings few economic indicators, but a particularly key one in the form of the February merchandise trade balance (Thu), where the main issue will be whether the very tentative stabilization in seasonally adjusted exports seen in January proves to be more than transitory. Very real concerns remain, of course, with respect to demand from Europe, as well as from China and other Asian countries-so a credible bottoming in exports would be surprising at this stage, likely shocking markets at least momentarily. The only other major data release scheduled is the January all-industry-activity report (Wed), which will combine the good industrial production and poor tertiary industry results of the month with figures for several smaller industries to portray the full output side performance of the economy in the first month of the new quarter. The comparison with December results (+1.3%) will not be favorable, potentially stunting GDP growth in the quarter. (Pierre Ellis) Emerging Markets India: Monetary easing likely. Central Bank Watch: Thailand India: Monetary Policy Easing Likely. Industrial production gained 6.8% year-on-year in January, an improvement over the upwardly revised annual rate posted in December (2.5% year-on-year), and above expectations (Consensus: 2.1% y/y; DE: 3.5% y/y). It is highly unlikely that the better January number will weigh sufficiently on policymakers estimations as to prevent what is likely to be further monetary easing by the Reserve Bank of India in the near-term. For one thing, the acceleration of the manufacturing component (from a 2.6% annual gain in December to 8.5% year-on-year in January), which drove the increase of the IP index, was entirely due to an extraordinary (hard to explain and even harder to sustain) 42.5% year-on-year gain in the production of consumer non-durables. The rest of the categories either fell or posted a modest gain. Capital goods production, for example, fell 1.5% year-on-year; intermediate goods, a decline of 3.2% year-on-year, and durable consumer goods a fall of 2.7% year-on-year. Meanwhile, headline annual WPI inflation has declined substantially and in a sustained manner over the past few months, and will probably

page 13 of 14

THE ECONOMIC STORYcontinue to move in that direction unless there is a major energy-price shock. In fact, one look at the components of the index suggest that despite the resistance of fuel-price inflation, primary-goods inflation, the major source of inflation during the past couple of years, has nearly vanished. (Francisco Larios) Central Bank Watch: Bank of Thailand will hold a meeting this week and is expected to continue to hold rates steady. In January, rates were lowered 25 basis points to 3.0% to aid in economic recovery. Thailand's economy is still reviving from the devastating effects from the flooding, which caused the third quarter's growth rate to sink to -9.0% y/y. Thailand hopes that in addition to the easing of the monetary policy, GDP will rebound as factories continue to become fully functional again. The increased stimulus to revive the economy may pose a potential threat to prices in the coming months. However, recent inflation has declined to 3.3% y/y in February, a large drop from August's rate of 4.3% and the bank sees declining global demand as countering upward pressures from food prices and government stimulus measures. On oil prices, they are a concern, as the Bank estimates each $10 / bbl increase in prices boosts inflation by 30-40 bps. But, those worries will for now remain in the background given growth-supportive goals, allowing the bank to keep rates on hold for some time, barring a serious unmooring of inflation expectations. (Anne Hooper)

page 14 of 14