The Bad and the Ugly

Finally, the EU managed to find a decision on the ESM (as well as an overhauled stability pact and increased economic monitoring and surveillance measures). Coupled with the already agreed enlargement of the effective lending capacity of the temporary EFSF (as well as a broadening of its mandate), this is a significant step forward for the Euro project. I would have preferred if the EFSF would have been allowed to be buying government debt in the secondary market but overall, the measures are going in the right direction and show that the political support for the Euro remains strong. I am convinced that these steps reduce the risk of a systemic breakdown of the Eurozone (i.e. a break-up). Additionally, it seems that markets are starting to perceive a similar picture as correlations between peripheral government bond spreads to Bunds have been falling since early this month.
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.

The bad and the ugly: Italy/Spain diverge from Portugal/Ireland

Source: Bloomberg

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:

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

Is EMU really bad for the periphery?

Much has been written about the inability of the PIGS countries to adjust wihin EMU as they cannot devalue their currency vs. their most important trading partners (i.e. the other EMU members). This has frequently been given as a reason why these countries should or might leave the Eurozone. Should they leave, they can then significantly devalue their new currencies and growth will re-appear. I have previously argued that devaluation without default does not help as these countries suffer from the combination of a lack in competitiveness as well as an over-indebtedness problem. Just leaving the euro would make the over-indebtedness issue much worse (as the debts would remain re-denominated in the euro). But leaving the euro and defaulting would cause serious havoc on the financial sector as well as the sovereign.

Furthermore, a weaker currency alone does not guarantee an improved export performance. The chart below compares the evolution of the trade balance for PIGS as well as Iceland and the UK. The Icelandic Koruna has collapsed dramatically and indeed the Icelandic trade balance improved very sharply. However, also GBP weakened significantly in trade-weighted terms since the start of the financial crisis (in fact GBP weakened by approx. 20% vs. the Euro compared to 2007). But UK net exports have not moved significantly. Rather the trade deficit widened slightly. This is in sharp contrast to the development in the trade balance of Portugal, Spain, Greece and especially Ireland. As can be seen from the chart, the Irish trade balance improved by more than 10% of GDP and thereby helped to stabilise the Irish economy. Furthermore, also the Spanish, Greek and Portuguese trade developments provide support to GDP! So, yes as Iceland shows, a much weaker currency can help but as the UK shows, it does not need to be the case. More importantly as the PIGS show, even with a stable currency (the trade-weighted euro is at the same level as in 2007), trade developments can provide a significant positive impetus.

Development of the trade balance/net exports as a % of GDPSource: Eurostat

Another important topic is the development of unemployment. Yes, especially Spanish and Irish unemployment rates are extremely high. However, my opinion is that this is mainly a functiion of the previous construction bubble.
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

Source: Research Ahead, Statistics Iceland, Eurostat

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.

The Hawks have landed

I have been of the view that the ECB would start its next rate hiking cycle by June (see A higher ECB repo rate by June dated Feb. 2). At today's press conference, ECB president Trichet not only mentioned that the inflation risks have moved to the upside - which was largely expected - he also stated that growth risks have become balanced (from downside growth risks). Furthermore, he stated that "strong vigilance" would be warranted, usually a code word that the repo rate will be hiked at the next meeting (which Trichet confirmed when he said that a rate hike was possible at the next meeting, though not certain). In turn, my hawkish view of the ECB has been confirmed. The record low level of the repo rate of 1% was set during the height of the financial crisis and amid deflationary risks. This is just not the case anymore and starting a rate hiking cycle is fully warranted. The inflation as well as the growth environment (as well as monetary developments) suggest that rates should gradually rise over the next 2 years. I expect rates to move to around 2.5% by the end of Q1 2012 and 3% by the end of 2012.


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

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