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Central Bank Bets, Debt Defaults, Fiat's One-Man Show: Timshel

Commentary by Mark Gilbert

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Feb. 22 (Bloomberg) -- Betting on the monetary-policy intentions of the Federal Reserve and the European Central Bank is getting harder as the threat of faster inflation competes for attention with the prospect of slumping growth.

U.S. rates look certain to drop; predicting how low the Fed will go is much tougher. Policy makers in the euro area, meantime, seem reluctant to relax their vigilance against rising prices no matter how dire the economic outlook gets.

Futures traders yesterday trimmed the odds of a half-point Fed cut at its March 18 meeting to 82 percent from 92 percent the previous day. Bets were pared after the minutes of January's two- step reduction in borrowing costs said Fed officials would be willing to change course at a ``rapid'' pace once convinced their monetary medicine was working its magic on the economy.

Figures the day before showing consumer prices climbed by 0.4 percent in January, faster than economists expected, also helped dent convictions about how much scope the Fed has to bolster the economy -- and to help the banking system recapitalize -- by driving down short-term lending rates.

By late morning yesterday, however, a 2.5 percent Fed rate was once again deemed a near-certainty at 96 percent. The Federal Reserve Bank of Philadelphia's report showing manufacturing unexpectedly contracted the most since February 2001 rekindled concern that the U.S. is already in recession. Futures prices also suggest a 2 percent Fed rate by mid-year is a done deal.

Pay Settlements

In Europe, the 5.2 percent wage increase won this week for about 85,000 steelworkers in western Germany by IG Metall, the nation's biggest labor union, may stiffen the ECB's resolve to keep its key rate at the 4 percent level maintained since June 2007. The pay deal, which runs for 14 months, is the highest for the region in 15 years.

The European Commission yesterday cut its forecast for 2008 euro-area growth to 1.8 percent from the 2.2 percent anticipated in November. At the same time, though, it boosted its inflation forecast to 2.6 percent from 2.1 percent, which would put consumer-price increases at their fastest pace since the introduction of the common currency.

Economists expect growth to trump inflation concern. The median forecast is for a quarter-point ECB reduction in the second quarter to be repeated in the third, leaving the key rate at 3.5 percent for the rest of the year.

Among the dissenters expecting no change this year are Merrill Lynch & Co., Goldman Sachs Group Inc., ABN Amro Holding NV and Morgan Stanley.

Traders aren't giving up on hopes for a rate cut, though they have scaled back their ambitions. The December interest-rate futures contract currently trades at about 3.64 percent, up from as low as 3.31 percent at the beginning of last week though still below the current three-month money-market rate of 4.37 percent.

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Credit spreads, which measure how risky investors perceive corporate debt to be, have surged to levels far higher than the likelihood of companies not repaying their debts would suggest.

The Markit Crossover Index, which aggregates prices on the credit-default swaps of 50 European companies with high-risk ratings, reached a record 615 basis points this week, while the main Markit iTraxx Europe index of 125 investment-grade companies climbed to 135 basis points from 91 basis points two weeks ago.

At those levels, investors are being paid enough to compensate for 20 defaults in the Crossover index and 13 in the main index, according to credit analysts at BNP Paribas SA. Those implied default rates of 10 percent and 2.3 percent, respectively, are far higher than the historical averages of 3.9 percent and 0.2 percent.

``The Crossover index is currently pricing in a scenario in line with the worse on record, whereas the main index compensates investors for default rates 5.5 times higher than the highest recorded in the past 50 years,'' the BNP analysts wrote in a research note published yesterday. If fortune does indeed favor the brave, it could be time to buy.

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Investors should pray that Sergio Marchionne, the chief executive officer of Fiat SpA, hasn't grown tired of leading Italy's biggest manufacturer.

Fiat shares slumped in early trading on Feb. 15 after Italian newspaper MF reported that Marchionne was considering quitting to take the top job at UBS AG. ``No, I'm not going there,'' Marchionne told reporters in Milan later that day.

The stock closed 0.15 percent higher that day, bucking a 2 percent decline in the Euro Stoxx 600 Index.

Yesterday, Marchionne was named as non-executive vice chairman of UBS as Europe's biggest bank by assets refurbished its management after reporting a fourth-quarter loss of 12.5 billion Swiss francs ($11.4 billion). Marchionne said in a statement that his new role is ``absolutely compatible'' with his Fiat responsibilities.

Investors aren't so sure. By midday Italian time yesterday, Fiat shares were trading at 14.77 euros, down 1 percent from where they opened. The Euro Stoxx 600 Index, by contrast, was 1 percent higher.

Fiat shares have more than doubled since Marchionne took the helm in June 2004, after losing 80 percent of their value in the previous four years. They have slipped more than 20 percent in the past six months.

When Marchionne joined, Fiat had suffered 11 consecutive quarterly losses. He began his tenure calling his new charge a ``chronic underperformer.'' He sacked a bunch of managers, slashed costs, and oversaw the introduction of refurbished models including the Grande Punto compact and the iconic 500 small car.

In October, he delivered his 11th quarterly profit gain in a row. Of the 26 analysts who cover the company, 19 recommend investors should ``buy'' shares, four mark it as a ``hold'' while only three say ``sell.'' Should Marchionne relinquish the wheel, Fiat investors may want to find a different ride.