The ECB is becoming more hawkish

There has been an increase in the hawkishness by some ECB members, be it Bini-Smaghi last week or Mersch today . With the next ECB meeting being one week away, the ECB council seems to be moving towards the view that inflation risks are rising whereas the recovery becomes more sustained - at least in the core countries and given the relative size, also for the Eurozone average. It remains my opinion that the ECB will raise rates by June (see A higher ECB repo rate by June dated Feb 2) but keep liquidity provision ample. As the chart below shows, the peripheral markets have calmed down. 10y Spanish, Italian and Belgium yields have stopped rising and moved in a range over the past months.

10y peripheral yields have stopped rising, except in Portugal

Source: Bloomberg

Only the Portuguese situation has continued to worsen. To me it looks like the other Eurozone countries are trying to force Portugal into a bail-out while at the same time announce the overhaul of the EFSF. Such a solution could - if done properly - lead to a further calming in the peripheral crisis. Furthermore, an overhauled EFSF would be acting like a second monetary institution alongside the ECB but effectively be in charge of long-term peripheral yields. As a result, the ECB can concentrate again on its main policy tools - the repo rate and liquidity provision.

Accordingly, my basic views still hold:

Policy tool	Direction	Expected stance
Repo rate (ECB)	Higher	Less accommodative
Liquidity provision (ECB)	Unchanged	Ample liquidity
Peripheral bond yields (EFSF)	Lower	Less restrictive

A higher ECB repo rate by June

It is my belief that the ECB will start its next rate hiking cycle by June this year. The 1% repo rate was established in an environment where the Eurozone economy was contracting sharply and in combination with the financial market crisis threatened a deflationary depression. In the meantime, the aggregate Eurozone data show that growth has recovered back to around trend whereas headline inflation has moved above 2% and also core inflation rate is on the rise again after having hit a low in mid 2010. Furthermore, credit availability is on the rise again (see also Monetary developments in the Eurozone will soon call for higher rates dated 28 January). As a result, monetary policy is getting even more accommodative!

However, neither the state of financial markets, nor the real economy are warranting this exceptionally low repo rate much longer and the ECB should start to remove some of its accommodation via raising the repo rate. On the other side, the banking sector is still depending on the ECB’s liquidity provision measures and its weak solvability suggests that this will remain the case for longer. In turn, the ECB can continue to provide ample liquidity – but at a higher price – to support the banking sector. Finally, a reformed EFSF can be established as a second monetary authority besides the ECB with the aim of capping bond yields of fundamentally weak countries. I have long been of the opinion that a substantial bond buying programme by the ECB/EFSF could break the adverse feedback loop in the periphery (higher yields worsen the budget deficit and are a headwind for the economy, both acting to worsen the already poor fundamental outlook and driving away bond investors, leading yields even higher). In fact, if done in a sensible manner, the EFSF could start a virtuous circle whereby lower peripheral bond yields reduce the deficit (via lower interest rate payments) and weaken the restrictive monetary environment for the peripheral economies, thereby helping growth. This in turn will improve the fundamentals for the peripheral credits and help to bring back private investors into the market, further lowering yields.

Policy tool	Direction	Expected stance
Repo rate (ECB)	Higher	Less accommodative
Liquidity provision (ECB)	Unchanged	Ample liquidity
Peripheral bond yields (EFSF)	Lower	Less restrictive

Overall, I expect that we will be left with a higher repo rate (a less accommodative environment for the core countries), lower peripheral bond yields (a less restrictive monetary environment for the peripheral countries) but an environment where liquidity continues to be ample.

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:

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

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.

Merry XMas and a Happy New Year

This is my last blog post for the year as I will be hitting the slopes in Switzerland from this weekend onwards.

In my blog post Finally some good news dated December 1, a day ahead of the last ECB meeting, I wrote: "we are likely to get a timid response by the ECB, just enough to improve sentiment towards risky assets in general in the short term but not enough to provide a real lasting solution."In the meantime the amounts the ECB bought during that period have been published. In the week up to Dec 3, EUR1.965bn of bond purchases have been settled and EUR2.667bn during the last week. While this constitutes a clear pick-up in terms of ECB bond purchases compared to the previous weeks/months, it remains too small and far away from what would be needed to provide more than just a very short term pause in the peripheral's downward spiral.
Given that market liquidity is usually drying up in the period leading to XMas and New Year, theses small ECB purchases seem to have been enough to fuel a short covering rally by some dealers in bonds and even more so in peripheral equity markets where for example the Spanish IBEX was able to rally by more than 10%.
However, the underlying problems for the peripheral economies (an unsustainable debt path coupled with a lack of competitiveness) remain. Additionally, the purchases are not large enough to break the adverse feedback loop. The high yields the peripheral countries have to pay render the debt situation even worse - be it for the sovereign as well as for its banks and corporates/households - leading to higher deficit and slowing down growth even more. Furthermore, given the huge volatility in market yields, sticking to peripheral bond positions becomes more difficult even for investors who think that current spreads adequately reflect fundamental risks. As realised volatility rises, the value-at-risk of the peripheral bond positions increases and hence to keep risks in check, the nominal positions has to be reduced nonethless, leading to even higher yields and higher volatility.
I argued previously that a significant increase in ECB bond purchases could help a lot to break this adverse feedback loop. It would for one lower yields (and with that reduce costs for the sovereigns/its banks/corporates/households) and it could also - if done in a more transparent manner than at present - lower market volatility and hence value-at-risk for investors in respective bonds. Both would help to lure investors back into the market.
However, the ECB seems very reluctant to go down that route and seems to keep its buying as low as possible. This is enough to cause some stability in a thin pre-holiday trading environment, but not enough to get through the funding heavy first months of the new year.
As a result, the peripheral downward spiral remains intact and 2011 promises to see Portugal and then Spain to have to revert to the EFSF before the end of Q2. I expect that at that stage a more lasting solution will be found (probably some kind of E-Bond or bond buying programme, however, judging from recent political rhetoric, it will be called differently). If that would still not happen, then Belgium and later Italy promise to be next.
So, for the time being, enjoy the crisis pause the ECB has provided to celebrate XMas and New Year but get ready for the showdown in 2011!

Just Blame Germany

It has become fashionable to blame Germany for the current crisis in the Eurozone. Most arguments encompass one or more of the following: Germans don't consume enough, Germany has a large current account surplus which hurts the rest of the Eurozone, Germany has conducted a beggar-they-neighbour policy over the past decade via internal devaluation and wage restraint, Germany exerts pressure on the peripheral countries to engage in way too strong deflationary austerity measures which renders their situation even worse, Germany refuses to pay for the periphery via more financial help be it in the form of a substantially larger EFSF or the introduction of EuroBonds, Germany is pushing ahead with its plans to introduce a sovereign default mechanism from 2013 onwards which leads investors to sell their peripheral debt now.
First, the arguments which blame Germany on the basis of their economic behaviour over the past decade seem mostly wrong: yes, Germany has a current account surplus, a relatively high savings ratio/low consumption, a highly competitive economy and it engaged in substantial internal devaluation via wage restraint. What we should not forget though is that a) just as the peripheral countries were profiting from very low real yields during the past decade amid the German economic malaise, Germany suffered from too high real yields amid the periphery's boom which rendered its economic weakness even worse and most importantly b) if Germany would not have done the corporate restructuring/budget consolidation/structural reforms, the German economy would be in a much worse shape at present. It would not be competitive (and therefore not have a current account surplus) and it would have a much larger fiscal deficit. As a result, if Germany would currently not have a current account surplus it could as well not be a net exporter of capital. Furthermore, if it would have a significantly higher fiscal deficit, it would as well suffer from the risk of rating downgrades amid an unsustainable debt path. Given that the German economy constitutes close to 30% of Eurozone GDP, the health of the German economy and the German sovereign is vital for the survival of the overall Eurozone. Would Germany still be economically sick, then approx. 50% of the Eurozone would be mired in deep depression with no one being able to help. It is great news that Germany could overcome its chronic weakness and is now in a state where it can provide stability to the Eurozone periphery.
Looking ahead, it remains my expectation that Germany will continue to outperform in economic terms as domestic consumption can pick up again. The low level of unemployment should lead to increasing real wage gains. Furthermore, the low level of unemployment coupled with the end of the structural reform period leads to an improvement in household sentiment and as a result an increase in the willingness to consume/a reduction in the willingness to save. This is further strengthened by the historically low level of real yields. The combination of a rising sum of wages and a lower savings rate should significantly fuel consumption growth over the next 2-3 years. This will lead to an improving internal balance within the Euorozone and eases the pressure on the periphery to restore competitiveness via significant deflation.
If there is one sensible argument to blame Germany relating to the past decade, then it is that they did not bring their banking system in order. The German domestic banking sector remains highly fragmented and barely profitable, a key reason why German banks have engaged in such massive investments in Eurozone peripheral debts. Would there have been more private banking mergers and would politicians have forced a consolidation of the Landesbanks and a change in their business model, the German banking sector could be much more resilient now. But it is not and that remains the key weak point of the German economy!

Additionally, I also think that to blame Germany for the latest surge in peripheral yields misses the point somewhat. Germany wants to introduce a default mechanism for states from 2013 onwards. Some observers suggest that this is the reason why investors have started to dump their peripheral bond holdings and blame Germany for talking about potential default. However, it is mostly the same obsevers who have been suggesting that there is no way around the perihperal countries defaulting anyway (and maybe leave the euro). The only thing which the German proposal changes is that they want to have an institutional set-up for the limits of Eurozone sovereign solidarity.

Overall, one should also not forget that if Germany does not demand any austerity measures/reforms in exchange for financial support, then nobody will. It seems that the smaller core countries (for example the Netherlands, Austria, Finland) have a similar line as Germany but in the current negotiations dont have the same power. As a result, if Germany were just to bail-out the rest of the periphery then yes, the peripheral debt crisis would be solved for the time being. But the prize to pay would be a massive rise in moral hazard issues, risking an even bigger debt crisis further down the road where no-one would be able to lend support.

Finally, I remain in favour of some sort of Eurobond (I suggested earlier joint issuance for the part of debt being within the Maastricht Treaty criteria) and do hope that Germany will give in on this. But also here, it matters a great deal that incentives to conduct a sustainable fiscal policy and to remain economically competitive become stronger and are not weakened further.

But to repeat: the biggest mistake by Germany is that it did not restructure its German banking sector. Germany is the voice of the fiscally sustainable and economically competitive countries. If these countries do not have this strong voice anymore, then the door to a fiscal union with much higher moral hazard issues as well as a higher propensity towards inflation and a lower propensity towards innovation and productivity is open. Germany has shown that they are able to negotiate, stand back from their toughest demands and support the common currency project if need be and so far it does not look likey they are deviating from that course.