Monday, December 19, 2011
I see the following main advantages of this tender:
1. During the next year a significant amount of bank bonds will reach maturity (around EUR 800bn). Approximately one quarter of this are government guaranteed bonds which were issued after the Lehman bankruptcy and carried an original maturity of around 3 years. Currently, banks face a very difficult environment to issue bonds (even for covered bonds) and most likely would need to revert to a new scheme of government guarantees. However, in those countries where even the sovereigns face a challenging environment to issue bonds, government guarantees would provide only a limited insurance function. However, as banks can now fund themselves for 3 years at 1%, this ECB tender should go a long way in easing the refinancing burden during 2012. It secures medium-term bank liquidity at a very low rate. Furthermore, it eases the pressure for governments as the likely size of needed government guarantees drops. Hence, via this tender, the liquidity provision for banks via sovereigns is being substituted by the ECB!
2. Banks can fund illiquid SME loans at extremely favourable conditions (1% at present). The drawback though is that the necessary legal paperwork so far has apparently not been finished yet and hence it is not clear whether this applies already for this week’s tender or only for the next one in February. This has several effects. For one, banks don’t need to fund these loans anymore in unsecured markets. Hence, it takes the pressure of unsecured funding markets. Furthermore, it increases the positive carry of the bank loan book as funding costs drop sharply. Finally, it frees higher-quality collateral which banks can use for other secured transactions.
3. The refinancing costs for Eurozone banks should fall sharply (as they fund an increasing part of their balance sheet at 1%). This increases realized margins and should help to restore equity over time, improving bank solvability.
I am convinced that the easing of banks’ funding pain is also behind the improvement in the short-end dynamics of the Eurozone periphery over the past week. Especially for small and midsized banks which a) are not part of the EBAs Stress Tests and b) hold large shares of SME loans, this tender should significantly reduce the need to deleverage and on the margin improve the demand for (domestic) government bonds, especially those that trade above 1% yields and mature in around 1-3 years.
Overall, I expect the two tenders to result in a very large take-up by Eurozone banks. However, it is likely that the February tender will be significantly larger given that so far the necessary legal paperwork for accepting bank loans seems not to be finalised yet. However, I do not think that this action is enough to break the adverse feedback loop and the real test will happen from around mid-January onwards, when the sovereign funding spree starts in earnest.
I wish all my readers a happy festive season and a good start for 2012!
Thursday, December 15, 2011
Thursday, November 3, 2011
So far the ECB has always set the repo rate for the average of the Eurozone, i.e depending on the outlook for inflation and growth for all of the Eurozone. Additionally, they never cut the repo rate when the nominal growth rate of the Eurozone was still so much above the repo rate as it is now. At the start of the cutting cycle in 2001, the spread between nominal growth (for the previous 12 months) and the repo rate was almost 0 and in 2008 it was negative. Currently, nominal growth is running significantly above the repo rate (+3% yoy up to June 2011). Even assuming zero real growth in both Q3 and Q4, nominal growth only drops to 2,1% by year end. Besides, the repo rate is currently already at low levels.
Overall, the ECB seems to have moved towards a fundamentally more dovish interpretation of its mandate which threatens price stability in the "strong" Eurozone countries but at the same time helps to restore internal balance in the Eurozone. I stick to my long held multi-year bullish view on the German economy which has just received additional support.
Thursday, October 27, 2011
Personally, I beg to differ. First, it was clear from the start that the plan would lack details (what else could one have expected?), but this does not make it any worse. Yes, uncertainty surrounding the Greek PSI deal as well as the likely success of the changes in the EFSF will prevail and yes, we are likely to get more bad news from several Eurozone countries/banks. However, a voluntary Greek solution is far better than a hard default would have been and given the bank recapitalisation scheme should not threaten the banking system. Furthermore, The ECB provides unlimited term funding (with the 13m tender in December lasting into 2013), engages in a new covered bonds buying programme to kickstart primary market issuance and some Eurozone countries will likely reintroduce state guarantess for new bank bonds. Additionally, the new EFSF wil be able to insure new issuance by Italy, Spain and Belgium for about the next three years (if it has to insure all new issuance). This drastically reduces the risk of a buyers strike for these countries. Given that all three countries at current yields do not suffer from insolvency but rather from the risk of illiquidity, these measures - together with the ability of the ECB to continue buying bonds in the secondary market - have the ability to break the sovereign debt-deflation spiral. In turn, this would also provide some relief for the asset side of the banking system.
Overall, I see a substantial probability that (on the assumption the ECB can continue with its SMP and Italy adheres to the promised structural reforms) the joint Eurozone sovereign debt and banking crisis has reached a tipping point. With that the markets should turn their focus away from a systemic financial crisis and move towards a focus on growth and inflation. Here the news out of the US remains constructive and I also expect the Asian central banks to take their foot from the brake as inflation slows down markedly over the next 3-6 months. In the Eurozone, the risk of a wave of state and banking defaults has been reduced drastically (as states and banks are being kept liquid) but the price will be more austerity/structural reforms and hence weak growth in the affected countries. Italy and Spain promise to be in recession in 2012 and I expect French growth to be weak (albeit above 0%). However, I remain optimistic for the German economy given that German corporates should continue to gain market share in world markets and the domestic German economy should see an increasing contribution to growth amid high employment, increasing wage pressures and record low real interest rates. As a result, overall Eurozone growth should be relatively low but positive and I do not see a Eurozone recession. In this environment, I expect the ECB to continue with its liquidity provision measures and SMP buying. However, I do not expect the ECB to cut rates anytime soon.
Thursday, September 15, 2011
Here is a brief summary of my current thinking. In short, I am not as negative as the prevailing sentiment and recent price action implies. I rather think that over a time period of a few months we will have an improving state of affairs:
a) Recession risk in the US slowly drops. Monetary policy in the US has turned highly accommodative amid record low/negative real yields and an ongoing high level of liquidity. Fiscal policy promises to be roughly neutral to slightly positive for growth. Additionally, the drag on growth from construction activity has passed. Finally, lower inflation (amid lower commodity prices) means that households have more spending power again despite weak wage growth. Overall US growth should be around 1.5% for the next quarters.
b) Emerging markets central banks will move from policy tightening to policy easing amid lower inflation risks. Most emerging markets are in a normal business cycle. Growth was high, fuelling inflation and with that the central banks tighten monetary policy to slow growth and tame inflation. However, as commodity prices have peaked during spring and have receded since, inflation rates should start to drop significantly soon given that energy and food play a significant role in emerging markets' consumption baskets. This should improve growth prospects again and helped developed market exports.
c) Eurozone growth will be significantly weaker than has been the case over recent quarters amid recession in Italy, Spain, Portugal, Greece and very weak growth in France. Germany will continue to do relatively well (approx. 2,5% real growth). However, I do not see a wave of sovereign and/or bank defaults.
First, I expect Italy to move into a recession. Italian treend growth has been low over the past decade (only around 1%). Low trend growth combined with significant fiscal tightening, high real yields (10y BTPei real yields are trading above 4.5%) and a banking sector which amid the sharp reduciton in market value and limited access to funding markets will likely tighten credit availability for corporates and households is very likely to drive growth into negative territory. In the case of France, some fiscal tightening coupled with a high dependency on weak economies such as Italy and Spain as well as the hit to the banking sector will result in weak but positive growth. For Germany, however, I expect that exports to non-Eurozone countries will remain strong (Germany should continue to gain market share in international markets) while domestic consumption should become a growth driver again as inflation eases (thereby fuelling real wage gains) and also construction should be strong amid record low real yields. Overall, Eurozone growth should come in around 1%.
More importantly, though, I do not expect a systemic financial crisis and no wave of sovereign and/or bank defaults. First, countries such as Italy and Spain are being kept liquid by the ECB's bond buying measures while Portugal and Ireland remain liquid amid their bail-out programmes. The banks are kept liquid via the ECB as well (unlimited term funding and now also 3m USD loans) and as announced yesterday the government-guaranteed bond funding programme will most likely be prolonged. With respect to Greece, I expect that the EFSF overhaul will be ratified by the national parliaments and the Greek bond swap will go ahead (even if the participation rate is below 90%). Once that happens, the threat of an immediate Greek default recedes significantly. One should not forget that the funding needs of Greece post the bond-swap will be very low. First, there will be almost no bond redemptions and additionally coupon payments should drop given that the interest rate Greece has to pay on the new bonds and the bail-out loans are lower than on the outstanting GGBs on average. Finally, if Greece really goes ahead with the privatisation programme, they can cover a large share of the remaining fiscal deficit/bond redemptions. Hence, the quarterly review by the Troika will lose in importance as the sums involved to be paid under the bail-out programme will drop sharply next year.
Overall, this constitutes a relatively upbeat outlook, especially in the light of the pricing action in recent weeks and should be met with higher equity markets and higher Bund yields over the longer term. Near-term, volatility promises to remain high. From a technical perspective, the German Dax has finally broken through its steep downward trendline on a closing basis yesterday (also the US Nasdaq) and starts to emit bullish signals. 10y Bund yields (and the Bund future) are trying to break a 6-weeks steep downward trend and should they close above 2% send a strong bond-bearish signal as well.
Wednesday, August 10, 2011
What are the implications?
1. Banks have already been backstopped since 2008 via liquidity/capital injections/guarantees. This will continue and keep the banking sector afloat. The same now counts as well for the Eurozone sovereigns. Some of the peripherals might technically be insolvent, however, they are all kept liquid by either the EFSF (Greece, Ireland, Portugal) or the ECB as in the case of Italy and Spain (and potentially other sovereigns). Hence, a wave of sovereign defaults is also off the table. In turn, another systemic financial crisis can be called off (at least for now).
2. Nominal bond yields are turning Japanese. As the Fed depresses UST yields and the ECB caps Eurozone peripheral yields, spread products should come back into investors focus. Reasons are that there is no other way to earn yield (given that 5y UST trade below 1%) and as mentioned above the risk of another systemic financial crisis has dropped sharply given the ECB's capping of Italian bonds. Furthermore, the liquidity injections by the ECB, SNB and BoJ (and potentially also the BoE at a later stage) will also fuel the demand for spread products.
3. However, while nominal bond yields are turning Japanese (Low across the maturity and credit spectrum), below the surface the story is vastly different. In Japan nominal bond yields are low because of negative inflation whereas real yields are positive. In contrast, US nominal bond yields are low due to negative real yields coupled with moderate inflation. As an example: 5y Japanese yields are trading around 0,35% with 5y real yields trading around +0,65%, meaning that implied break-even inflation is around -0,3%. In the US, though, 5y UST trade around 0,95% with 5y TII real yields at -0,76% and the implied break-even inflation rate at 1.75%. Hence, the monetary stance in the US is very accommodative on an absolute as well as on a relative basis compared to Japan. In turn, even though the US economy will continue to deleverage over the next few years and with that there will be little self-sustaining growth (personally I think trend growth in the US should have fallen to around 2% and actual quarterly growth number should oscillate around this trend). However, this extreme level of accommodation should prevent the US economy from falling into another recession and from deflation becoming entrenched. Finally, it supports the notion made above: negative real yields will force investors to bring their money elsewhere).
Overall, spread products should be the clear winner of the latest policy actions and I expect that the recent widening seen in the credit world will start to reverse again.
Tuesday, August 9, 2011
Looking ahead, it seems that in the developed world only the central banks are left to do the heavy lifting. The BoJ has already intervened to weaken the Yen and also the SNB is injecting more liquidity into the domestic financial market. Additionally, also the ECB is providing longer-term liquidity to the banking sector again. Finally, it seems that over the next few months, both the US Fed as well as the BoE might well do another round of quantitative easing. Overall, this creates another global liquidity glut to support asset prices. Furthermore, as the global banking sector is being backstopped via the massive liquidity injections and also the weaker Eurozone sovereigns are being kept afloat via the bail-out programs and the ECB bond buying, the risk of another systemic financial crisis due to a wave of sovereign and bank defaults should be reduced.
In turn, near-term growth in the developed market world should take a hit (personally, though, I do not see another wide-spread recession). However, also inflation should fall markedly given that the ongoing deleveraging should keep core inflation rates suppressed whereas the implosion in commodity prices should lead headline inflation markedly lower (this in turn should see emerging markets starting to ease policy again before the year is over). Hence, near-term nominal growth rates should be very low. Furthermore, given that the banking sector as well as sovereign are being kept afloat and given that available liquidity should be abundant, volatility should drop markedly again and nominal bond yields should be low not only for the safe governments (such as Germany, US, Switzerland) but pressure towards lower yields should intensify again for the wider government bond segment.
Tuesday, August 2, 2011
Monday, July 4, 2011
Worries about the global growth environment have intensified over the past months, mainly due to three reasons:
a) the Eurozone sovereign debt crisis and the threat of a near-term Greek default
b) the weakening of the US economy with a string of below-expectations data releases since the beginning of March
c) high inflation rates in developing economies, forcing central banks to tighten monetary policy, thereby threatening a hard landing in a host of countries, most notably China
Furthermore, the Japanese catastrophe has lead to a sharp reduciton in output, however, here most agree that this is a temporary phenomenon and the economy should rebound sharply in the months ahead.
I am convinced that over the next weeks and months, we will see significant improvements on all three fronts and hence a positive global growth environment which as of now does not seem to be priced in bond as well as equity markets.
First, the probability of a near-term unorderly Greek default has dropped substantially. To be sure, despite the second bail-out programme for Greece, the Eurozone debt crisis will not go away soon. Greece is de facto insolvent and remains mired in recession and the periphery in general will suffer from weak growth for years to come. However, the unorderly Greek default scenario would likely have resulted in another systemic crisis for the European financial sector. Furthermore, it would have likely lead bond yields in the large peripheral countries - Italy, Spain and Belgium - sharply higher. At the least this would have caused another recession in these countries but could as well result in a full blown buyers strike for peripheral sovereign debt!
But this scenario seems to have been averted for now and I expect peripheral bond markets to stabilise further in the weeks ahead which in turn should help general sentiment.
Furthermore, as I have been stating on several occasions, I expect the US economy to show an improving growth picture during the summer months. I have mentioned previously that I am convinced that the economic weakness in the US so apparent since early spring is largely down to a combination of temporary factors, most notably seasonal adjustment factors which are too large, adverse weather, high commodity prices and supply disruptions due to the catastrophes in Japan. Seasonal factors, however, are reversing as July/August is usually a weaker period for the economy. As a result, seasonally adjusted data for these two months should show an improvement vs. the usually strong spring period. Furthermore, supply disruptions have been reported to be weakening and hence production in the affected plants (and the supplier of other input goods used) should slowly move back to normal. On top, the substantial recent drop in commodity prices - just in time for the summer driving season - is equalling a rise in households real net income and hence should support consumption. Overall, therefore, I expect that US economic data will surprise positively in the weeks and months ahead.
Finally, given the recent drop in commodity prices, headline inflation rates, especially in developing countries where commodities play a more important role in consumption baskets and hence in determining inflation rates, should also start to fall again. This in turn, should mean that an increasing amount of emerging markets central banks will soon reach the end ot their monetary tightening cycle, thereby reducing the threat of a hard landing. Additionally, lower commodity prices will c.p. lead to higher real incomes for households and hence support consumption growth.
Wednesday, June 29, 2011
As I suggested in When should Greece default dated May 25, I don't think that the second bail-out for Greece merely amounts to throwing good money after bad money. While Greece will likely need to restructure its debts in a few years' time, a default now would lead to a devastating outcome for the Eurozone overall given the state of the Eurozone banking system and especially given the risk of contagion to the large sovereign debt markets of Spain and Italy. Even though the way forward will remain bumpy for the peripheral Eurozone sovereigns and some important hurdles remain, I think that the peripheral woes might calm down somewhat during the next few weeks and even months. For one, as mentioned a devastating near-term default scenario has become less likely. Additionally, as reports suggests, a sensible roll-over plan for maturing Greek debts is being negotiated between the banks and the various Eurozone states. This roll-over plan should help Greece to partially refinance maturing bonds and the banks to partially reduce their Greek exposure without taking an accounting loss. Even though it might be deemed a selective default by some rating agencies, this solution should help limit the negative spill-over to the other peripheral debt markets.
Overall, therefore, the US economy should increasingly show signs of recovery as summer progresses.
Such an environment - increasing risk appetite, improving growth backdrop and higher ECB repo rates - does not bode well for USTs and Bunds. Furthermore, the technical market situation has also worsened over the past few days. The 10y Treasury future broke and closed below its upward trend which was in place since early April. Today also the Bund future and 10y Bund yields followed. The chart below shows the 10y Bund yield. As can be seen, the downward trend has been tested four times since early April. Today it broke above which would trigger a technical sell signal if confirmed on a closing basis.
Finally, adding to the negative outlook for UST is the end of QE2. Even though the Fed will continue to re-invest maturing bonds, the support for the market is clearly dropping. As an example, at the last 7y UST auction, the Treasury sold USD29bn. Dealers bid for USD 62.3bn and were allocated USD 11.4bn. On June 1 (one day after the auction settled), the dealers sold USD 5.4bn back to the Fed in the Permanent Open Markets Operation and a week later sold another USD 3.2bn. Given that the dealers knew they could sell the bonds back to the Fed just a few days after the auction, they were happy to bid large amounts. Now, however, this game is over and we should expect to see a significant drop in dealer bids at upcoming auctions and in turn intensifying price pressures.
Friday, June 10, 2011
To quote from the Beige Book: "Auto sales were mixed but fairly robust in most of the country, though some slowing was noted in the Northeastern regions. Widespread supply disruptions--primarily related to the disaster in Japan--were reported to have substantially reduced the flow of new automobiles into dealers' inventories, which in turn held down sales in some Districts. Widespread shortages of used cars were also reported to be driving up prices....Supply disruptions related to the earthquake in Japan led to reduced production of automobiles and auto parts in several Districts. The Cleveland District noted a sharp drop in auto production, the Atlanta and St. Louis Districts also saw production fall, and auto deliveries were reported as having declined in the Richmond District. The Atlanta District said lost production in its region would be made up later in the year. Contacts in the Chicago District said that contingency plans to deal with supply disruptions were helpful in mitigating the effects. High-tech firms in the Boston and Dallas Districts reported that shortages of parts, due to disruptions in Japan, had adverse effects on business."
Essentially, the Beige Book suggests that there was a significant negative supply shock occuring, especially in the auto industry but also ini IT manufacturing. The implications are significant, for one, cars manufactured in Japan can not be shipped (as they are not produced), furthermore, cars manufactured in the US cannot be produced as important parts are missing. But also the production of complementary parts should be affected significantly given that less production in cars means less demand for these parts. Furthermore, whereas a negative demand shock should result in lower production and lower prices, a negative supply shock should result in lower production but higher prices. This is exactly what we have been seeing over the past months. The chart below shows the Mannheim Used Vehicle Value Index. This index reached a new high in May.
Additionally, according to the April US trade data released yesterday, US imports of automotive vehicles, parts and engines dropped by 13% from March! This seems to be entirley due to reduced imports from Japan. Overall Japanese imports dropped by 25% (passenger cars - dropped by 70%, auto parts by 21% and technology imports by 14%).
In turn, the weakness in auto production and auto sales should not be down to a worrisome drop off in demand but rather to a temporary negative supply shock. Given that these supply disruptions should also be felt in complimentary parts used in the auto manufacturing process as well as in the technology sector, it can explain a substantial part of the weakness in the US manufacturing sector over the past two months. However, once the supply disruptions ease, the situation in the US manufacturing sector should improve again. As this article published yesterday suggests, the situation in the Japanese semiconductor industry has been improving significantly: "Following the devasting earthquake, tsunami and electrical power crisis that severly impaired both the Japan and world semiconductor industry, many supply chain players now report that production has reached pre-earthquake levels with minimal risk to future shipments. In addition, the Japanese government has excluded semiconductor fabs and many chemical plants from the 15% power cuts planned for this summer." However, reports from some auto parts manufacturers suggest that in this sector it might take a bit longer before production has been fully restored.
Overall, though, the negative supply shock should slowly ease over the next few months. Coupled with a turn in the seasonal factors used to adjust economic data, the US economic reports covering the June-August period should increasingly paint a friendlier picture again.
Tuesday, May 31, 2011
I am convinced that seasonal adjustments have played an important role in recent negative data surprises. Seasonal factors assume a significant re-acceleration of the US economy during spring following a weaker winter period. Given that the economy continues to operate with a high level of spare capacity, the seasonal swings in the economy should be less pronounced than has historically been the case (companies will fire fewer workers than usual during the winter and summer months as they have less workers anyhow and with that they will hire fewer workers during spring and autumn). Furthermore, employment in highly seasonal sectors dropped sharply during the last recession (-2mln employees in construction, -2mln in manufacturing since end 2007) whereas it grew in non-seasonal sectors (+1.4mln in education and health services). This as well should render the economy less seasonal. However, as the chart below shows, the seasonal adjustments do not reflect this.
The chart below shows the seasonal adjustments used in the US employment report to adjust the payrolls number, in blue the seasonal adjustment over the past 12 months and in red the average seasonal adjustment over the previous 10 years. Given that on average, employment was slightly higher over the past decade than now (133mln vs. 131mln), and because the economy should exhibit less seasonality, the seasonal factors should have become lower. Instead, they have even become larger!
As a result, seasonally adjusted data should be weaker than the underlying trend during the seasonally strong periods of spring and autumn and the data should be stronger than the underlying trend during the seasonally weaker months in summer and winter.
Wednesday, May 25, 2011
Speculation about a Greek restructuring (or in the milder form a reprofiling) have reached a new high. Reason is that in the short term Greece needs to secure the payment of the next tranche from the EU/IMF bail-out package, otherwise it is running out of cash at the beginning of July. But looking into 2012/2013 reveals that even with the bail-out package Greece faces a funding shortfall of around EUR 60bn (see chart below, courtesy of RBC). It was assumed that by 2012 Greece would be able to access the capital markets again to secure parts of its financing needs. However, now this appears very very unlikely. In turn, Greece either needs more bail-out funds or its need to restructure its debt (at least do a maturity lengthening exercise). While I have for a long time stated that Greece is insolvent (see for example the Greek Fire series which I started in autumn 2009), I think that a restructuring now needs to be avoided and should be delayed into 2013.
The second key reason for a delayed restructuring is that the high sovereign debt of Greece is not the cause of the problem but only a symptom. Greece has very weak sovereign institutions/weak governance. As a result of that the Greek state has a substantial revenue problem (much more so than an expenditure problem). The chart below shows estimates for the shadow economy (in % of GDP) vs. the ranking in the Ease of Doing Business index constructed by the World Bank. Tax compliance in Greece is very low and Greece's shadow economy is estimated to be around 25% of GDP, by far the highest in the Eurozone. Furthermore, Greece ranks only #109 for ease of doing business. Additionally, Greece ranks also lowest for a Eurozone country in the Corruption Perception Index by Transparency International (#78).
These structural shortcomings have burdened Greece for a long time and are the root cause for the high debt burden. If Greece reduces its debt via default, then the Greek sovereign will still face this revenue problem and the Greek economy its structural shortfalls. In turn, it would only be a matter of time before Greece indebtedness starts soaring again and a new debt-cycle commences.
As a result, first Greece needs to strenghten its governance and improve its economic structure before it should restructure. If it restructures now, this will ease the pain and hence reduce the pressure for such measures.
Monday, May 16, 2011
Hence, as I expected, it is not only the export industry which drives this cyclical upswing but the domestic economy is increasingly contributing to growth. As unemployment is dropping and real wage growth should pick up, the longer-term outlook for domestic consumption remains bright. I think there are two more important factors which will cause the domestic economy to do increasingly well:During the first decade of the Euro, Germany has suffered from a tight monetary environment (weak credit growth and much too high real yields). This depressed domestic investment by the corporate sector and led the savings ratio higher (an increase in the savings ratio was also a rational response to increased economic insecurity amid the high number of reforms in social security and labour markets earlier last decade). Now, the monetary environment is becoming increasingly accommodative (historically very low nominal yields coupled with above-trend inflation means that real yields are extremely low; additionally given the strong economy credit availability is improving). In combination with the healthy economy and a high level of competitiveness, the corporate sector should increase its domestic investments. Additionally, given higher job security (amid the low level of unemployment), the savings ratio of private households should drop markedly. Finally, weak consumption by German households during the past decade suggests that there should be a lot of pent-up demand, especially for durable goods and housing.
The chart below shows the development of 10y German real yields (defined as 10y nominal Bund yields minus German yoy headline inflation). As can be seen, the monetary environment has become significantly easier over the past two years given that first nominal bond yields have become much lower and inflation has recently moved higher again. Furthermore, current German real yields are the lowest since the start of the Euro!
10y German real yields (10y nominal Bund yield - German inflation rate) at record lows
Source: Bloomberg; Research Ahead
Immigration trends are shifting. Earlier this week the German statistics office published the latest immigration data for 2010. It showed that on a net basis some 128.000 people have moved into Germany. This is a significant shift from earlier years and marks the highest net immigration since 2003. It is down to both, more foreigners moving to Germany and less German residents moving abroad. I am convinced that immigration will increase further. A key factor for immigration are relative economic prospects. Given that the German economy is doing so well and hence creates a lot of jobs whereas a host of other European countries are doing poorly with high unemployment rates, suggest that the attractiveness of Germany has increased significantly. Significant positive migration would positively affect trend growth (as it provides more labour to the economy and increases private sector demand) and help to ease the demographic problems Germany is facing in its social security system.
Wednesday, May 4, 2011
The above chart shows the history of this misery index for the US (black: unemployment + adjsuted inflation, blue: +budget deficit). As can be seen, including the budget deficit, this misery index is back to the level prevailing during the stagflationary 70s. While at that time, unemployment and inflation were the problem whereas budget deficits were fairly low, this time unemployment and the deficit are high, whereas inflation has so far remained low.
A country can lower unemployment if it reverts to more fiscal spending but at the expense of a higher budget deficit. Alternatively, a looser monetary policy could also be used to lower unemployment with the risk of fuelling inflation further down the road. As a result, there is a trade-off between these three variables which limits cyclical macro-economic policy. I am convinced that a lot of the economic problems (=surge in the misery index) are of a structural nature for the over-indebted/over-spending/over-leveraged US/UK and peripheral Eurozone countries. What is needed to significantly and sustainably lower the misery index again is time, structural reforms and improved corporate competitiveness.
Friday, April 29, 2011
The latest economic data - be it real activity, inflation or monetary data - all support the case for further significant rate hikes to 2-2.25% by year end (which means the ECB will likely take a 50bp step, probably in Q4). Today's 2.8% estimate for yoy CPI in April marks the highest inflation rate in the ECB's history, barring the end 2007-end 2008 period when, however, the repo rate stood at 4% (and was raised to 4.25% in the summer 2008) and just before the deflationary impact of the Great Recession depressed inflation rates again. Now the repo rate stands at only 1.25% and given the surging inflation rates has increasingly accommodative effects on the already strongly growing North-Eastern countries, most notably Germany. And to reiterate: For the economically weak peripheral countries the level of the repo rate has lost in importance as bond yields have become much more dependent on credit developments (Spain, Italy, Belgium) or are a matter of negotiations with the EU/IMF (for Greece, Ireland, Portugal). Additionally, for the banking sectors in these countries it remains more important to secure funding than the price they pay for this funding and here the ECB still provides ample liquidity.
Furthermore, today's M3 data - where yoy growth came in at 2.3% - only look low at first sight. I have long been of the opinion that looking at M3 does not provide an accurate picture about the state of the economy/future inflation risks. Given that M1 constitutes roughly half of M3, and M1 is extremely influenced by the ECB's balance sheet developments, M3 is very dependent on the ECB's measures as well. When the ECB significantly lengthened its balance sheet in 2008 to support the financial system, it also helped to stabilise M3. However, the related growth in M3 was not a precursor of inflation. Now that the ECB stopped growing its balance sheet, M3 growth is being depressed. In turn, M3 growth remains distorted and does not provide accurate signals about future inflation pressures.
Tuesday, April 5, 2011
Now to be sure, I fully agree that the economic environment varies greatly between the north-eastern Eurozone area and the periphery (and will continue to do so for some years) with the periphery needing lower rates than the north-east. However, I am also convinced that given the Eurozone debt crisis, the repo rate has lost in importance for the fiscally weak peripheral countries (or to put it differently: the monetary transmission mechanism in the periphery is impaired). The relationship between the repo rate and peripheral bond yields has weakened dramatically ever since the Eurozone sovereign debt crisis started. The effect of a higher repo rate does therefore not need to translate into higher funding costs which add to cyclical economic weakness. The chart below shows the rolling regression coefficient of changes in 10y bond yields ono changes in the 6x9m EONIA forward rate (over 120 business days). There is a relatively stable relationship between changes in the EONIA forward rate and changes in the 10y Bund yield (with changes in the EONIA forward rate being mirrored almost 1:1 by 10y Bund yields). The R2 value is around 75% (i.e. around 75% of the changes in 10y Bund yields are explained by changes in the EONIA forward rate).
For peripheral bond yields, this is not the case. Since the outbreak of the Greek crisis in spring 2010, the correlation between changes in the EONIA forward rate and 10y Portuguese, Spanish and Italian yields moved into negative territory (i.e. higher peripheral yields went hand in hand with a lower EONIA rate and vice versa). However, regression coefficients have statistically not been different from zero and R2 values have been below 1%. Hence, statistically, peripheral bond yields are currently not dependent on changes in the EONIA forward rate (and with that on ECB rate action). This assessment is being confirmed by the developments over the past weeks. While 10y Bund yields rose by approx. 20bp since the last ECB meeting at the beginning of March (when the ECB prepared the market for a rate hike), 10y BTP and 10y Bono yields are slightly lower by around 5bp. On the other side, Portuguese yields rose sharply amid the political crisis and expectations that Portugal will have to apply for a bail-out soon. Hence, fundamental credit developments seem to be the main driver of peripheral bond yields and not the ECB repo rate!
With respect to the Irish and Greek sovereign, the ECB repo rate is even of much less importance. The bond market currently remains shut for these two countries (with Greece only performing some bill issuance) and they fund themselves via the IMF/EU/EFSF at pre-defined interest rates. Changes in the ECB repo rate have no meaningful effect on the interest expense of these countries. In fact, Greece could recently negotiate a reduction in the interest rate it gets charged on the bail-out loans and Ireland tries to achieve the same. For these two countries, the interest rate they have to pay are therefore a function of politics and not of the ECB repo rate.
For Eurozone banks, a repo rate rise will mean a higher funding cost. While the strong banks can easily withstand a higher funding cost, for the weak Eurozone banks the most important issue is to get access to enough liquidity with the price being is of secondary importance. And here the ECB seems willing to keep liquidity provision ample. As long as this remains the case, the effects on the banks should be low.
For households, credit on new loans will become more expensive but that is wanted for households in the north-east. For households in the periphery, the volume of new loans has been low anyhow and as a result the slowing effect via this channel should prove fairly limited. The larger problem might be that a significant amount of outstanding mortgage loans in Ireland, Spain and Portugal are variable rate loans (linked to Euribor). Given the rise in Euribor rates, this will at the margin negatively affect consumption.
Overall, given that Ireland and Greece currently do not fund themselves in the bond markets and credit fundamentals are more important for the bond yields of the other peripheral countries than the level of the repo rate whereas for the weak banks it is more important that they continue to have access to enough liquidity than the price they pay for this liquidity, the effects of a higher repo rate on the economically weak peripheral countries should be very limited. Only households relying on variable rate mortgages will see a drop in their real spending power. For the north-eastern Eurozone countries the effects of a higher ECB repo rate should have more direct consequences (albeit the level of rates remains very accommodative) given that here the monetary transmission mechanism is working much better. Overall, I previously stated that fundamentally a higher repo rate is warranted (amid the level of real growth, inflation but also given improving monetary developments) and I do not see strong reasons why it should constitute a policy mistake.
Friday, March 25, 2011
The chart below shows that Portuguese and Irish spreads continued to widen. This should not come as a big surprise given all the negative news out of Portugal (collapse of the government, significant rating downgrades) which renders a bail-out very likely and the ongoing problems in the Irish banking sector, a lack of agreement about a potential cut in the interest rate of the bail-out loans and the absence of the ECB in the secondary market. On the other side, spreads of Italian and Spanish bonds have tightened considerably.
This is probably down to an improved growth outlook for the Spanish as swell as Italian economies (it has also been mirrored in equity markets where the Spanish IBEX and the Italian MIB index show the largest year-to-date gains besides Greece). Also in the case of Spain, it seems that the austerity measures taken by the government over the past two years as well as the steps to bail-out the banking sector are starting to help restore confidence. Moreover, it suggests that contagion from a likely Portugal bail-out should prove minimal. This is not only a great development for Spain - which has been frequently cited as a likely bail-out candidate following Portugal - but for the entire Eurozone. Additionally, given the size of the Spanish bond market, a self-reinforcing widening cycle (and a likely bail-out) would have caused tremendous losses on the already weak European banking sector.
Finally, these developments are support my notion that for peripheral bond yields it is much more important what the EFSF does/how the liquidity situation evolves, than whether the ECB hikes its repo rate. 10y Spanish government bond yields have fallen by some 50bp since mid January. To be sure a 5% 10y rate is still restrictive for the Spanish economy, however, it is less restrictive and as such will help the economy to stabilise and the sovereign to reduce the budget on the margin. Furthermore, as spread volatility drops, more buyers might be enticed back into investing in Spanish bonds, with the potential of establishing a positive feedback loop (lower yields=better for the deficit and the economy=improving fundamentals=lower credit risk=more bond buyers=lower yields). At the short end, the situation is similar and 2y yields fell 60bp over the past two months.
As a sidenote, these developments support the case for an early ECB rate hike. Furthermore, I expect Spanish and Italian bonds to perform further vs. Bunds over the medium term. Therefore, my expectations for the development of monetary policy remain the same as they have been since early this year:
Repo rate (ECB)
Liquidity provision (ECB)
Peripheral bond yields (EFSF)
Monday, March 7, 2011
The chart below shows the relative size of the construction sector (i.e. construction employment relative to total employment) at the peak of the bubble vs. the latest unemployment rate. Clearly it is not a perfect fit, but with an R2 larger than 60% it is quite good. In general, the larger the previous construction bubble, the higher current unemployment. This should not come as such a surprise as construction is usually very much a domestic sector (i.e. within construction exports and imports are not that important). In turn, once a construction bubble bursts, a lot of people will get unemployed in the domestic economy (because there are not many construction imports), even with a sharply weaker currency (because there are not many construction exports). As these people get unemployed, domestic demand is weakened and employment drops as well in other sectors.
The larger the previous construction bubble, the higher current unemployment rates
Overall, the development in net exports for the PIGS countries is encouraging so far. To expect that unemployment - especially in Spain and Ireland - would drop fast if they had their own much weaker currency seems illusionary given the size of the previous construction bubble. Once such a bubble bursts, the costs must be borne and can not be exported away. EMU does not seem to be the main problem for PIGS.
While the developments in Iceland seem encouraging as net exports have grown significantly amid the sharply weaker currency which has also helped to keep unemployment down, the situation in the UK raises a warning flag. Net exports are not rising despite a weaker currency and the only effect seems to be to raise inflation, thereby eroding living standards.
I remain of the opinion that the Eurozone will rebalance over a 3-5 year timeframe with a relatively high real growth rate and high inflation in the north-eastern economies while the PIGS will suffer from relatively low real growth and limited inflation.