From Systemic Crisis to Global Recession?

Despite the ECB having started to buy Italian and Spanish government bonds, financial markets remain in panic mode. However, the key driver now seems to be rather the threat of another global recession than of another systemic financial crisis. On the one side, growth is weak in the developed world where the sovereign debt crisis forces the weaker countries into austerity measures and prevents the stronger ones from adopting significant fiscal easing programs. On the other, the emerging market countries are still suffering from high inflation rates and have enacted monetary tightening measures to cool the economy and ease inflation pressures, hence they can't yet ride to the rescue as well. In turn, markets are pricing a renewed global recession, sending equity markets, commodities and safe government bond yields sharply lower in turn (with the notable exception of gold).
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.

No Dolce Vita for Italian Bond Investors

The second bail-out program for Greece has failed to ease stress in the other peripheral markets. Rather to the contrary, the Eurozone sovereign crisis is reaching a new level as the downward spiral (higher interest rates leading to a weakened solvability leading to higher interest rates) has reached Italy. Italy was generally assumed to be relatively safe despite its high sovereign debt level of approx. 120% of GDP. Reasons have been that the banking system appears sound amid low leverage/high capital ratios and a high level of deposits (and in turn not much funding stress). Furthermore, indebtdedness of the private sector is low and the savings ratio high. Finally, the deficit was "only" around 4% in 2010 and Italy is one of the few developed economies with a primary surplus (i.e. a budget surplus before interest payments). As a result, despite the high level of sovereign debt, the projections for the debt-GDP ratio were looking for a relatively flat development, i.e. no worsening in the solvability. Furthermore, the risk that Italy would have to take over a significant amount of banking debt (as in Ireland) appeared remote as well as the risk that the domestic economy would implode (as in Spain).

10y Italian and Spanish government bond yields reaching new records

Source: Bloomberg

However, amid the combination of private sector involvement in Greece, a negative rating outlook for Italy (amid chronic growth weakness), only a half-hearted austerity program as well as weakness in political leadership might all have lead parts of the international investor base to start selling/hedging their Italian bond exposure, thereby starting to drive up interest rates. Even more threatening, though, is the implosion of bank shares and the potential for a wave of capital flight by the Italian households. Once Italians lose their faith in the political system as well as their banks, they will increasingly shift their money elsewhere. Such a wave of capital flight would seriously undermine the stability of the Italian banking system (as it deprives them of a key source of funding) and significantly weaken the domestic demand for Italian debt (by the households themselves which take their money elsewhere but also by the banks which suffer already from high losses on their BTP holdings and would then need to shrink their balance sheets as funding via deposits dries up). So far data by the ECB for the development of banking deposits does not showw a significant flight out of Italy. However, the data cover only the period up to June, i.e. just when the rout in the BTP market as well as in Italian banking shares really started. Furthermore, banking deposits in Italy have not been growing anymore since late 2008, contrary to previous years.

Development of banking deposits by state (Dec 2007=100): Italian deposits drying up?

Source: ECB

Overall, this negative feedback loop has been set in motion and it seems that only further strong action by either Eurozone politicians, the EFSF or the ECB can break this downward spiral. We would either need very strong growth impulses for the Eurozone economy from key export markets (potentially also via a much lower euro), a large investment program for Southern Europe and/or a massive buying program for peripheral government bonds. However, the EFSF does not yet have the ability to do that (probably this will only be possible from autumn onwards) and even if it would, its size remains too limited. This would leave the ECB to do the heavy lifting and restart its bond-buying program, but this time also for Italian bonds and in much much larger size. So far, though, the ECB seems reluctant to go down that route.

Watch out for a significant improvement in global growth prospects

I will be on vacation for the next weeks and restart blogging towards mid-August.

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.

CITI US economic surprise indicator: String of negative data is over

Source: Bloomberg

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.

Favorable base effects ahead: Agricultural commodities started to rally exactly a year ago

Source: Bloomberg

Especially prices for agricultural commodities have risen sharply since the beginning of July last year (see chart above) and the S&P GSCI Agricultural Spot Index almost doubled by mid-February this year, i.e. within less than eight months. However, since then it dropped by almost 20%. The chart below shows the year-over-year percentage changes in the agricultural index since July last year. As can be seen inflationary pressures from agricultural commodity prices have been extremely substantial. However, while at the beginning of June, agricultural prices were up 80% on a year-on-year basis, at the beginning of July, this fell to less than 50%. But even if it agricultural price do not drop any further, year-over-year price changes should continue to fall given the sharp rise which started exactly a year ago. Should prices stay at current levels, then the yearly rate of change should drop to +20% by the end of this month and to 0% by the end of September. Given these favorable base effects, inflationary pressure from high food prices should ease markedly in the months ahead, be it in the developed world and even more so in emerging markets. Even within the Eurozone, the weight of food prices in inflation is diverging widely. According to Eurostat data for 2010, the food sub-index had a weight of 10% in the overall price index in Germany. The economically challenged large peripheral countries, however, have a food price share of 16% for Italy and 17% for Spain. Hence, lower food prices should be more beneficial to the peripheral countries than the core. Typically, though, in emerging markets, food prices play an even more vital role.

Food price induced inflation pressures should drop off sharply (yoy %-change in Agricultural commodities)

Source: Bloomberg, ResearchAhead

Overall, therefore, growth prospects - be it in the US, the Eurozone, Japan, as well as across emerging markets - might well see a significant turn for the better over the next few months. Markets do not seem to reflect such a favorable scenario and equity prices as well as government bond yields appear too low. Hence, I remain of the opinion that 10y Bund and UST yields will move towards 3.75% by the end of autumn.

Winds of Change

I expect UST and Bund yields to rise into autumn. I am still of the opinion that the US economic slowdown which became apparent over the past months is a temporary phenomenon (see for example Now it's official: A temporary negative supply shock dated June 10). Furthermore, I continue to remain optimistic about the economic outlook for the Eurozone overall and especially Germany, warranting further rate hikes by the ECB. Clearly, though, the Eurozone sovereign debt crisis has put downward pressure on UST and Bund yields as well as on global risk asset prices. But as a second Greek bail-out is ready to be applied (on the basis that the Greek parliament votes in favour of the Medium Term Plan this afternoon), it seems that a near-term default scenario where Greece can not meet its coupon and redemption payments will be averted.
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.

10y Spain and Italian bond yields propelled higher by Greek default prospects

Source: Bloomberg

Overall, I expect that markets will slowly start to focus again on the underlying fundamental environment. And here I expect the news to become more favourable in the weeks ahead. I remain a proponent that the US economic slowdown apparent over the past months is largely transitory. Seasonal factors, adverse weather, high food and energy prices as well as supply disruptions following the earthquake in Japan have combined to create a difficult environment for the US economy since early spring. However, all of these headwinds are weakening and some even reversing: I frequently mentioned that the US economy should have become less seasonal than has been the case during previous years (given that the seasonal sectors - for example construction and manufacturing - have seen large job losses over the past 3 years whereas non-seasonal sectors such as health care and education have seen job gains) but seasonal factors have become even larger. In turn, seasonally adjusted data should paint too weak a picture during spring and too strong during July/August and winter. High energy and food prices have corrected over the past weeks with the RICI Agriculture Index being down by approx. 15% since early March and its Energy counterpart by almost 20% since early May. Finally, supply disruptions should ease during the next few months as the situation in Japan normalises.
Overall, therefore, the US economy should increasingly show signs of recovery as summer progresses.

CITI US Economic surprise index has stabilised and should turn up again

Source: Bloomberg

In the Eurozone, I expect the German economy to remain very strong. However, also France should see a pick-up in growth. French exports should react positively given that consumption in its main trading partner - Germany - is picking up whereas the economy in its second most important trading partner - Spain - is showing signs of stabilising. Despite ongoing recession in Greece and Portugal as well as ongoing low growth in Italy, aggregate Eurozone growth should remain well above 2%.
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.

10y Bund yields break above their 3-months upward trendline

Source: Bloomberg

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.

Now it's official: A temporary negative supply shock

In the last blog post I suggested that US economic data should turn around soon given that at least part of the apparent weakness during spring should be down to seasonality issues. These seasonal adjustments render the data weaker than the underlying trend during spring but should render the adjusted data stronger than the underlying trend during the June-August period. Clearly, though, the strong weakness in economic data relating to April and May has not only been down to seasonality issues. Also the previous rise in food and energy prices has eaten into consumers' pockets while adverse weather seems to have had a meaningful impact as well. However, the importance of one additional factor was revealed by this week's release of the Beige Book (which covers the mid April to end May period) as well as by yesterday's trade data for April: supply disruptions in the wake of the Japanese triple catastrophe (earthquake, tsunami and nuclear crisis). Given that the effects of these supply disruptions should be temporary and slowly start to revert, my view that economic data covering the June-August will likely surprise on the positive side again remains unchanged.

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.

Used Vehicle Prices reaching a record high

Source: Mannheim Consulting

But also price indications for new cars suggest the same: lower volumes but higher prices. Usually prices for new cars are not changed frequently (normally this is done when new models are being released). Instead of changing official prices, discounts are being adjusted and a higher discount is the same as a price reduction whereas a lower discount equals a price rise. The chart below shows the development of the industry wide discount percentage for the last 13 months. As can be seen, discounts have been reduced (from 12.9% in March, i.e. ahead of the supply disruptions to 11.4% in May).

Industry average discount percentSource: edmunds Auto Observer

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.

Growing probability of positive US data surprises

US economic data has disappointed significantly during the past three months. The chart below shows this with the help of the Citi US economic surprise index (in yellow). This was also one important factor driving US Treasury yields lower (in green). As a result, growth expectation for the current quarter as well as for the whole year have been scaled back. Besides overly optimistic previous expectations, key reasons are being thought to have been higher commodity prices, most notably for energy, ongoing weakness in the US housing market as well as supply disruptions related to the Japanese earthquake and nuclear disaster. However, I am convinced that a technical factor - seasonal adjustments - has played an important role but goes unnoticed (see below). Looking ahead, reduced expectations coupled with slightly lower energy prices and especially a turn in seasonal factors suggest that the US economy should start to surprise again on the positive side soon.

US data has been surprising on the downside since early spring

Source: Bloomberg

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.

Seasonal adjustments are reversing again as summer draws closer

Source: BLS, ResearchAhead

In turn, it is probably not a co-incidence that the Citi US economic surprise index topped out at the beginning of March. This is the time when data relating to February starts being released and as the chart shows, February is the start of the period with highly positive seasonal adjustment factors. However, we are now entering the seasonally weak June-August period. Togehter with reduced expectations, the probability is becoming substantial that US economic data starts to surprise positively again!

When should Greece default?

Greece is insolvent, however a restructuring/reprofiling should be postponed.

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.

Greek funding needs and financing shortfall

Source: RBC

I see two main reasons why a restructuring now is not advisable. First, contagion for the other weak peripheral countries as well as for the Eurozone banking sector would be truly devastating. Moody's already announced that in the case of a Greek reprofiling it would have significant adverse consequences for peripheral debt ratings. Furthermore, the market will most likely also punish peripheral sovereign issuers and lead interest rates significantly higher, rendering it even more difficult for these economies to grow and for the budget deficits to be reduced according to plan. Additionally, for the already weak Eurozone banks, such a course of events would significantly damage its capital base and risks shutting them out of the money markets, rendering their dependence on ECB funding even larger. However, if reprofiling/restructuring is postponed into 2012/2013, this risk of contagion should become lower. For other sovereigns the risk of contagion should decrease if in they use this time period to improve their fundamentals while for the weak banks it means they need to improve their capital base and reduce their holdings of peripheral debts. The latter can be done easily as maturing bonds - and a significant amount of peirpheral bonds will mature over the next two years - are not being replaced anymore.
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).

Weak institutions in Greece: Ease of doing business vs. shadow economy

Source: World Bank, IAW

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.

Germany is going strong

Barring short-term ups and downs, the multi-year outlook for the German economy remains very bright. 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 Don’t underestimate the German consumer dated Jan25). Germany has embarked on a multi-year virtuous circle with high real growth 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). I am convinced that even though consensus growth expectations have been raised somewhat, just how positive and long-lasting this growth environment will be remains vastly underappreciated. Last week’s much better than anticipated Q1 growth numbers (+1.5% qoq vs. +0.9% expected and remember that these numbers are not annualised) once again support this notion. As the German statistics office stated: “In a quarter-on-quarter comparison (adjusted for price, seasonal and calendar variations), a positive contribution was made mainly by the domestic economy. Both capital formation in machinery and equipment and in construction and final consumption expenditure increased in part markedly. The growth of exports and imports continued, too. However, the balance of exports and imports had a smaller share in the strong GDP growth than domestic uses.”
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.

Source: German Statistics Office

Finally, I remain convinced that a key factor for the market share of German corporates in the global export markets remains determined by the level of the Euro vs. the key competitors of the German industry. Here, Japan seems to be very important, not only for the auto sector but also for machinery and chemicals. As the chart below shows, the EURJPY cross rate has moved sharply lower since the start of the financial crisis (from around 170 to currently 115, i.e. c.p. Japan lost 30% in relative price competiveness vs. Germany) and remains close to 10-year lows. Coupled with production losses following the catastrophes in Japan, Germany should be able to take away market share from Japanese manufacturers.

Trade-weighted Euro and even more so EURJPY provide significant stimulus for Germany

Source: Bloomberg

Heaven Knows I'm Miserable Now

The misery index was used in the 1970s to show the stagflationary nightmare. It is constructed by summing up the inflation rate and the unemployment rate. The higher this index, the worse the economic situation for a country. The misery indexes I show below are constructed slightly differently. While I take the unemployment rate as is, I dont use the inflation rate directly but rather the deviation of inflation from 1.5% (thereby assuming that 1.5% is somehow a superior inflation rate, but it could equally be a different low but positive number). Reason is that a very low/negative inflation rate has also negative economic and social consequences. Additionally, I add the budget deficit to the inflation rate and unemployment rate. A high budget deficit has also negative economic costs and reduces current as well as future fiscal flexibility.

US adjusted misery index

Source: ResearchAhead

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.

Only Germany is on the bright side

Source: ResearchAhead

The chart above shows the adjusted misery index including the budget deficit for various economies. The UK shows a similar behaviour as the US. The Eurozone overall has as well seen a sharp rise in its misery index. However, the index is still at levels which were prevailing during the mid-90s. Finally, the German misery index has already dropped back to the levels which were prevailing at the height of the dot-com boom.

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.

More ECB rate hikes needed

I have long been of the opinion that the ECB will start to raise rates early (see A higher ECB repo rate by June dated Feb 2) but leave liquidity ample and that this would not constitute a policy mistake (see No ECB policy mistake dated April 5) as the North-Eastern countries need higher rates whereas the ECB repo rate has lost in importance for the fiscally challenged and economically underperforming peripheral countries.
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.

ECB Balance Sheet (in €mln)

Source: Bloomberg

I think that a much better indicator of inflation pressures than M3 growth is growth in M3-M1. M3-M1 is not distorted by the ECB's balance sheets actions and much better reflects supply and demand for funds in the banking sector and the real economy. The chart below shows yoy growth in M3-M1 compared to growth in M3. It highlights that in 2008 inflationary dangers were unprecedented (whereas according to M3 they were similar to late 2001), in 2009 deflationary pressures were larger than M3 data indicated and that by now inflationary pressures are similar to late 2005. Yoy growth in M3 of 2.3% is still the lowest in the history of the Euro, barring the period since the Great Recession. In turn, M3 data would suggest that inflationary pressures remain very low, whereas M3-M1 data shows that inflationary pressures have risen significantly.

M3-M1 does not track M3 all the time

Source: ECB, ResearchAhead

Finally, growth in M3-M1 fits well with headline inflation and has a good fit with the ECB repo rate (in fact a much better fit than M3 data). The chart below compares yoy growth in M3-M1 with the ECB repo rate as well as with yoy headline CPI. As can be seen, growth in M3-M1 tracks the ECB repo rate well, especially since around 2002. It explains why the ECB waited so long in 2005 to hike rates (whereas growth in M3 would have suggested a much earlier rate hike) and again why it chose to hike rates at the start of this month despite low M3 growth data.

Growth in M3-M1 tracks the ECB repo rate well

Source: ECB, Bloomberg, ResearchAhead

Overall, activity, inflation as well as monetary data all suggest the need for a significantly higher ECB repo rate. If history is any guide, the current environment would be compatible with a repo rate of at least 2%! I expect the ECB to take us there by year-end (and to hike further in 2012).

No ECB policy mistake

Readers of my blog know that I have been expecting the ECB to start hiking rates for quite some time (see for example A higher ECB repo rate by June dated Feb 2). At its last press conference ECB president Trichet strongly hinted at a rate hike for the upcoming meeting this Thursday which caused bank economists' to change their expectations and consensus is now indeed looking for a rate hike this week. However, it frequently is being stated that such a step would be a policy mistake as it would aggravate the economic problems in the periphery and thereby worsens the sovereign debt crisis. For example in the Bloomberg article Trichet risks burying ailing nations with interest-rate rise it stated that "the normalization of rates from a record low of 1 percent will disproportionately hurt Spain, Greece, Portugal and Ireland, while failing to nip inflation threats in Germany." Additionally, a bank economist was quoted with "Greece, where government debt is set to rise to 156 percent of GDP by 2014, will face an additional debt-service charge of 1.6 percent of GDP if market borrowing costs gain 1 percent on the back of the ECB raising rates, Paolini estimates."
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).

Reduced repo rate iimportance: regression of 10y yields on 6x9m Eonia forward

Source: Bloomberg, Research Ahead

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.

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

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.