A fundamentally more dovish ECB

I have to admit that I did not expect the ECB to cut rates already at today's meeting as I thought the governing council would not deviate from its script it has followed over the past 12 years.
So far the ECB has always set the repo rate for the average of the Eurozone, i.e depending on the outlook for inflation and growth for all of the Eurozone. Additionally, they never cut the repo rate when the nominal growth rate of the Eurozone was still so much above the repo rate as it is now. At the start of the cutting cycle in 2001, the spread between nominal growth (for the previous 12 months) and the repo rate was almost 0 and in 2008 it was negative. Currently, nominal growth is running significantly above the repo rate (+3% yoy up to June 2011). Even assuming zero real growth in both Q3 and Q4, nominal growth only drops to 2,1% by year end. Besides, the repo rate is currently already at low levels.

Nominal Growth vs. ECB Repo Rate: Spot the difference

 

Source: Bloomberg, ResearchAhead

However, while having been wrong with the repo rate cut forecast, I think it will facilitate the rebalancing process within the Eurozone. In those countries where the credit creation process/the monetary transmission mechanism is working (i.e. those without a sovereign debt/banking crisis), the lower repo rate will support domestic growth. The countries are in the North-Eastern part of the Eurozone, most notably Germany, and have been growing at a healthy rate already. The lower repo rate pressures real yields even lower from already historically low levels. With that it will support domestic investment and pressure the savings ratio lower. Furthermore, with wage pressures already building in Germany, inflation should also stay above 2% over the medium term. A stronger domestic German economy supports the overall Eurozone economy while a higher German price level renders it easier for the periphery to regain competitiveness.

Overall, the ECB seems to have moved towards a fundamentally more dovish interpretation of its mandate which threatens price stability in the "strong" Eurozone countries but at the same time helps to restore internal balance in the Eurozone. I stick to my long held multi-year bullish view on the German economy which has just received additional support.

Underwhelmed?

The European politicians have delivered yet another package to break the Eurozone sovereign debt and banking crisis. Having read a few reports by the sell-side I get the impression that in general there is some relief that the  politicians managed to get a deal done but besides that the analyst community does not see that the low point in the crisis has been reached already. Reasons given are that the plan lacks details, does not solve the sovability issues on the table and essentially largely kicks the can down the road again.
Personally, I beg to differ. First, it was clear from the start that the plan would lack details (what else could one have expected?), but this does not make it any worse. Yes, uncertainty surrounding the Greek PSI deal as well as the likely success of the changes in the EFSF will prevail and yes, we are likely to get more bad news from several Eurozone countries/banks. However, a voluntary Greek solution is far better than a hard default would have been and given the bank recapitalisation scheme should not threaten the banking system. Furthermore, The ECB provides unlimited term funding (with the 13m tender in December lasting into 2013), engages in a new covered bonds buying programme to kickstart primary market issuance and some Eurozone countries will likely reintroduce state guarantess for new bank bonds. Additionally, the new EFSF wil be able to insure new issuance by Italy, Spain and Belgium for about the next three years (if it has to insure all new issuance). This drastically reduces the risk of a buyers strike for these countries. Given that all three countries at current yields do not suffer from insolvency but rather from the risk of illiquidity, these measures - together with the ability of the ECB to continue buying bonds in the secondary market - have the ability to break the sovereign debt-deflation spiral. In turn, this would also provide some relief for the asset side of the banking system.
Overall, I see a substantial probability that (on the assumption the ECB can continue with its SMP and Italy adheres to the promised structural reforms) the joint Eurozone sovereign debt and banking crisis has reached a tipping point. With that the markets should turn their focus away from a systemic financial crisis and move towards a focus on growth and inflation. Here the news out of the US remains constructive and I also expect the Asian central banks to take their foot from the brake as inflation slows down markedly over the next 3-6 months. In the Eurozone, the risk of a wave of state and banking defaults has been reduced drastically (as states and banks are being kept liquid) but the price will be more austerity/structural reforms and hence weak growth in the affected countries. Italy and Spain promise to be in recession in 2012 and I expect French growth to be weak (albeit above 0%). However, I remain optimistic for the German economy given that German corporates should continue to gain market share in world markets and the domestic German economy should see an increasing contribution to growth amid high employment, increasing wage pressures and record low real interest rates. As a result, overall Eurozone growth should be relatively low but positive and I do not see a Eurozone recession. In this environment, I expect the ECB to continue with its liquidity provision measures and SMP buying. However, I do not expect the ECB to cut rates anytime soon.

Are there any optimists left?

First a sorry for having been inactive over the past weeks, I just had a lot going on but I really hope to write again more frequently.

Here is a brief summary of my current thinking. In short, I am not as negative as the prevailing sentiment and recent price action implies. I rather think that over a time period of a few months we will have an improving state of affairs:
a) Recession risk in the US slowly drops. Monetary policy in the US has turned highly accommodative amid record low/negative real yields and an ongoing high level of liquidity. Fiscal policy promises to be roughly neutral to slightly positive for growth. Additionally, the drag on growth from construction activity has passed. Finally, lower inflation (amid lower commodity prices) means that households have more spending power again despite weak wage growth. Overall US growth should be around 1.5% for the next quarters.
b) Emerging markets central banks will move from policy tightening to policy easing amid lower inflation risks. Most emerging markets are in a normal business cycle. Growth was high, fuelling inflation and with that the central banks tighten monetary policy to slow growth and tame inflation. However, as commodity prices have peaked during spring and have receded since, inflation rates should start to drop significantly soon given that energy and food play a significant role in emerging markets' consumption baskets. This should improve growth prospects again and helped developed market exports.
c) Eurozone growth will be significantly weaker than has been the case over recent quarters amid recession in Italy, Spain, Portugal, Greece and very weak growth in France. Germany will continue to do relatively well (approx. 2,5% real growth). However, I do not see a wave of sovereign and/or bank defaults.
First, I expect Italy to move into a recession. Italian treend growth has been low over the past decade (only around 1%). Low trend growth combined with significant fiscal tightening, high real yields (10y BTPei real yields are trading above 4.5%) and a banking sector which amid the sharp reduciton in market value and limited access to funding markets will likely tighten credit availability for corporates and households is very likely to drive growth into negative territory. In the case of France, some fiscal tightening coupled with a high dependency on weak economies such as Italy and Spain as well as the hit to the banking sector will result in weak but positive growth. For Germany, however, I expect that exports to non-Eurozone countries will remain strong (Germany should continue to gain market share in international markets) while domestic consumption should become a growth driver again as inflation eases (thereby fuelling real wage gains) and also construction should be strong amid record low real yields. Overall, Eurozone growth should come in around 1%.
More importantly, though, I do not expect a systemic financial crisis and no wave of sovereign and/or bank defaults. First, countries such as Italy and Spain are being kept liquid by the ECB's bond buying measures while Portugal and Ireland remain liquid amid their bail-out programmes. The banks are kept liquid via the ECB as well (unlimited term funding and now also 3m USD loans) and as announced yesterday the government-guaranteed bond funding programme will most likely be prolonged. With respect to Greece, I expect that the EFSF overhaul will be ratified by the national parliaments and the Greek bond swap will go ahead (even if the participation rate is below 90%). Once that happens, the  threat of an immediate Greek default recedes significantly. One should not forget that the funding needs of Greece post the bond-swap will be very low. First, there will be almost no bond redemptions and additionally coupon payments should drop given that the interest rate Greece has to pay on the new bonds and the bail-out loans are lower than on the outstanting GGBs on average. Finally, if Greece really goes ahead with the privatisation programme, they can cover a large share of the remaining fiscal deficit/bond redemptions. Hence, the quarterly review by the Troika will lose in importance as the sums involved to be paid under the bail-out programme will drop sharply next year.

Overall, this constitutes a relatively upbeat outlook, especially in the light of the pricing action in recent weeks and should be met with higher equity markets and higher Bund yields over the longer term. Near-term, volatility promises to remain high. From a technical perspective, the German Dax has finally broken through its steep downward trendline on a closing basis yesterday (also the US Nasdaq) and starts to emit bullish signals. 10y Bund yields (and the Bund future) are trying to break a 6-weeks steep downward trend and should they close above 2% send a strong bond-bearish signal as well.

Turning Japanese?

This week has seen significant action by the major global central banks. For one the ECB has started buying Spanish and Italian government bonds while the Fed has stated that the funds rate will stay exceptionally low for at least the next two years (Not to forget that the BoJ and the SNB are also injecting liquidity into the financial system to keep their currencies from appreciating ever further).
What are the implications?
1. Banks have already been backstopped since 2008 via liquidity/capital injections/guarantees. This will continue and keep the banking sector afloat. The same now counts as well for the Eurozone sovereigns. Some of the peripherals might technically be insolvent, however, they are all kept liquid by either the EFSF (Greece, Ireland, Portugal) or the ECB as in the case of Italy and Spain (and potentially other sovereigns). Hence, a wave of sovereign defaults is also off the table. In turn, another systemic financial crisis can be called off (at least for now).
2. Nominal bond yields are turning Japanese. As the Fed depresses UST yields and the ECB caps Eurozone peripheral yields, spread products should come back into investors focus. Reasons are that there is no other way to earn yield (given that 5y UST trade below 1%) and as mentioned above the risk of another systemic financial crisis has dropped sharply given the ECB's capping of Italian bonds. Furthermore, the liquidity injections by the ECB, SNB and BoJ (and potentially also the BoE at a later stage) will also fuel the demand for spread products.
3. However, while nominal bond yields are turning Japanese (Low across the maturity and credit spectrum), below the surface the story is vastly different. In Japan nominal bond yields are low because of negative inflation whereas real yields are positive. In contrast, US nominal bond yields are low due to negative real yields coupled with moderate inflation. As an example: 5y Japanese yields are trading around 0,35% with 5y real yields trading around +0,65%, meaning that implied break-even inflation is around -0,3%. In the US, though, 5y UST trade around 0,95% with 5y TII real yields at -0,76% and the implied break-even inflation rate at 1.75%. Hence, the monetary stance in the US is very accommodative on an absolute as well as on a relative basis compared to Japan. In turn, even though the US economy will continue to deleverage over the next few years and with that there will be little self-sustaining growth (personally I think trend growth in the US should have fallen to around 2% and actual quarterly growth number should oscillate around this trend). However, this extreme level of accommodation should prevent the US economy from falling into another recession and from deflation becoming entrenched. Finally, it supports the notion made above: negative real yields will force investors to bring their money elsewhere).

Markit iTraxx Europe Crossover Index: Recent widening likely to reverse again

Source: Bloomberg

Overall, spread products should be the clear winner of the latest policy actions and I expect that the recent widening seen in the credit world will start to reverse again.

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.