Friday, January 28, 2011

Monetary developments in the Eurozone will soon call for higher rates

Today's release of the Eurozone M3 data came in slightly below-consensus at a yoy rate of 1.7% (and a 3m mav of 1.6%). Clearly such low numbers are not compatible with my expectations of a potential ECB rate hike around June this year (assuming that a broadened EFSF solution can be agreed upon in March)? Not so fast. For one, the 3m M3 moving average rate has been rising, suggesting that yoy growth will pick up soon also. More importantly, I have long been of the opinion that growth in M3-M1 is more important than in M3. This is because M1 is roughly around half the size of M3 and M1 has been extremely heavily influenced by ECB action. As the ECB started to dramatically lengthen its balance sheet, M1 growth increased significantly, helping to stabilise M3. Effectively, this was the ECB pushing on a string. However, now that this effect is past, yoy M1 growth has dropped from 14% in Aug09 to below 5% in Dec10. Clearly as M1 is stalling, this keeps the growth of M3 in check as well. But to gauge whether inflationary pressures are starting to build in the economy, the difference between M3 and M1 seems more important as here the central bank has less of a direct influence and changes should be influenced much more by developments in the real economy. Additionally, the growth in M3-M1 seems to be related more closely to the path of the ECB repo rate than the growth in M3 as the chart below suggests. And this growth in M3-M1 has recovered strongly over the past months, from -10.5% yoy in Dec09 to -0.4% yoy in Dec10.

Growth in M3-M1 suggests that the ultra-low repo rate might not be warranted much longer anymore
Source: ECB, ResearchAhead

The ECB engaged in its first rate hiking cycle in November 1999. At that time, yoy growth in M3 was still falling (reaching a low point in March 2001, just when the repo rate topped out. On the other side, M3-M1 growth whad just moved into positive territory. In its seconed rate hiking cycle which started in December 2005, the M3-M1 growth rate was also below 1%! The recovery in M3-M1 is a good sign for the economy, however, it suggests that the ultra-low policy ratge of 1% will not be warranted much longer. As a result, monetary developments do not stand in the way of an early ECB rate hike.

For Germany, the current monetary environment is not only very accommodative, it is even getting easier. Yesterday, the German Bundesbank published its January bank lending survey. The key take aways were that German banks continued to ease lending standards towards German customers (corporates and households). German banks stopped tightening credit standards for coroporate customers in Q2 2010 and started easing in Q3 2010. Demand for credit by corporates continued to increase strongly, this time mainly due to increased investment plans. But also households are increasing their credit demands related to house purchases. This supports my notion that besides the drop in realised real yields - amid ongoing low nominal yields but rising inflation - also credit availability is improving which both means that the monetary environment in Germany is indeed becoming ever more accomodative. As a result, especially the domestic German economy should become stronger over time and German growth less dependent on growing export demand.

Overall, this is an environment where from a monetary policy perspective, the following actions would be necessary:
a) A broadened mandate for a larger EFSF gives it the power to engage in peripheral bond buying, which will lead to a less restrictive monetary policy environment in the periphery.
b) The ECB slowly hikes the repo rate which will lead to a less accommodative monetary policy environment in the core
c) The ECB continues to provide ample liquidity for the banking system.

Finally, some Friday fun stuff:

Tuesday, January 25, 2011

Don't underestimate the German consumer

One of my major topics has been the extremely favourable short as well as long term outlook for the German economy (see for example the publication German Wirtschaftswunder 2.0 from May last year as well as the blog post German Wirtschaftswunder revisited from Nov 3). Germany is at the start of a multi-year virtuous circle with real growth around 3% on average due to structural reasons (high competitiveness of the German economy, relatively healthy fiscal situation, end of the decade-long high real rates period) as well as cyclical reasons (extremely accommodative monetary policy environment which via higher inflation and an improvement in credit availability becomes even more accommodative). While this thesis was initially an extremely out-of-consensus view, in the meantime expectations have shifted somewhat, especially with respect to the German industry amid the export-led recovery. However, compared to my base case expectations remain muted, especially with respect to the outlook for domestic consumption (as well as domestic investment). This should not come as a surprise given the decade long disappointing performance of German consumption (see chart below) where the real level of retail sales has not grown at all. Nevertheless, I am convinced that domestic German consumption growth will be strong in the years ahead.

German real retail sales (ex autos/gas, 2005=100)
Source: Bloomberg

Over the past decade, the German consumer has disappointed again and again as consumption remained weak and the savings ratio high. However, looking ahead the outlook is very bright. Essentially, consumption growth depends on the change of the sum of wages (and social transfers) being paid to households as well as the change to the savings ratio. Over the past decade, both have acted to depress consumption. Additionally, a host of structural reforms have acted to increase perceived uncertainty, resulting in higher precautionary savings. The combination of a cut in social security, an increase in the pension age, a watering down in job protection on the one side, coupled with a corporate sector re-establishing its competitiveness lead to a significant rise in unemployment early in the decade and a drastic reduction in perceived economic safety of a vast part of the population. In turn, not only remained real incomes more or less unchanged, but the reduction in the perceived personal security - amplified by the high real rate environment - propelled the savings ratio higher, a truly rational response by private households.
Now, however, the situation is turning around dramatically. The low level of unemployment/historic record level of employment is fuelling wage pressures and we should see marked rises in wage gains over the next years. Furthermore, at the same time it is also helping to restore economic security and coupled with lower real yields will see a large and prolonged drop in the savings ratio. Furthermore, the success of the German cash-for-clunkers scheme in 2009 has not only shown that German consumers react to incentives but also that the stock of durable goods (in this case cars) is relatively outdated. This should not come as a surprise given the low propensity to consume during the past decade, however, it suggests that there is a great level of pent-up demand for durable consumer goods in Germany.
Finally, amid the sustained drop in German unemployment the voices about an increasing lack of well-educated personnel are growing ever louder. Besides fuelling wage-gains, it is also very likely that it will fuel immigration of well-educated people. For one, these might be Germans who emigrated during the past decade given the poor economic circumstances prevailing in their home country but now find themselves in an underperforming economy such as Spain or Ireland. Additionally, it is also likely that Germany will start to attract a rising number of young and well-educated people moving from the peripheral Eurozone countries amid a lack of jobs. This article in the Swiss newspaper NZZ (in German) looks at some Italian people having moved to Berlin recently given the combination of better job availability and lower costs of living in the German capital. The result of increased immigration of well educated people will not only be to help consumption growth but also to improve trend growth.
From a longer-term perspective, German equities continue to appear attractive, though a shift from the more export-dependent companies/sectors towards the more domestic oriented companies/sectors makes sense. Additionally, the construction sector might as well show some signs of life following the 15-year long slump also fuelled by the increased willingness to spend as well as low real yields.

German construction orders (real value based index, 2005=100)
Source: DeStatis

Wednesday, January 12, 2011

Do they finally get it?

The much feared Portuguese auction went well earlier today with the Treasury being able to place EUR1.25bn of 4y and 10y bonds, the high end of the intended 0.75bn-1.25bn range. The main reason for this outcome should be seen in the significant buying of peripheral bonds by the ECB earlier this week. This put the dealer community short in peripheral debt including Portugal and thereby provided much support for today's auction. Furthermore, it saw peripheral bond spreads tighten sharply over the past days. This shows that ECB bond buying can have a significant impact on market dynamics. If the ECB effectively provides a cap on peripheral bond yields, then it can a) also draw back private investors into the market again as it reduces near-term potential mark-to-market losses whereas the carry available through the high bond spreads renders investments attractive again, b) change the underlying debt dynamics of the peripheral countries (c.p. lower yields mean that deficits are being reduced) and c) lead to a less restrictive monetary environment for the countries in question which supports growth. Additionally, each of these effects is reinforcing each other and therefore significant ECB buying has the potential to establish a positive feedback loop (Establishing such a positive feedback loop via a significant bond buying programme is what I suggested the ECB should do in Monetary easing in the wrong places or will the real ECB please stand up dated November 17). This would just be the opposite of the dynamic which has been at work so far where higher yields work to worsen deficits, reduce growth and deter investors, resulting in higher yields again.
Furthermore, proposals to increase the size of the EFSF and to broaden its mandate which would include buying of government bonds in the secondary market have been doing the rounds. This could even result in an improvement over a bond-buying programme by the ECB as it prevents the ECB from becoming too much involved in political issues. Furthermore, it would allow the ECB to continue concentrating on its main policy instruments (the setting of the short-term repo rate and the provision of liquidity).

Bolder ECB action causes significant yield drop in peripheral bonds (10y benchmarks)

Source: Bloomberg

I am convinced that bold and sustained action by the ECB (or potentially the EFSF) can establish a positive feedback loop which would result in a fundamental change in the dynamic of Eurozone government bond markets. It would go hand in hand with an aggressive and lasting tightening of peripheral government bond spreads as well as the pricing of an upcoming rate hike cycle into the Bund curve. So far, it is too early to tell and we would need to see follow-through action by the ECB. My guess is that an increase in the size of the EFSF and a broadening in its mandate could come together with a bail-out of Portugal. First, the actual size of the EFSF would not be enough to provide a bail-out for Spain - the domino behind Portugal - and therefore the urgency for change is intensifying even further at that stage. Second, I think that it would need a concrete event (the bail-out of Portugal) for such a decision to be taken to appease the public in the core countries. Economically it would make more sense to go down that route already now (i.e. somewhat preemptively) but politically it might be harder to do.
Overall, I remain of the opinion that Ireland, Portugal and Spain have the ability to solve their combined over-indebtedness and uncompetitiveness issues over a time horizon of 3-5 years (Greece will have more problems to do so). Establishing a positive feedback loop via a massive bond-buying programme would go a long way towards providing these countries with the necessary time. I have argued already in May last year (Wirtschaftswunder 2.0 - longer-lasting high growth period ahead for Germany) that re-establishing corporate competitiveness will occur not only via sustained lower growth & inflation in the periphery but also via higher growth & inflation in the core countries, especially Germany. Furthermore, as the Eurozone balances again internally, its external current account balance will move from being around zero to a significant surplus. I see no reason yet why I should deviate from this scenario which compared to most commentators constitutes a positive outlook.