Research Ahead

US Data Warning: Heightened Risks for Negative Surprises

2012-02-01T09:53:00.000+01:00

Amid a multi-month string of positive data surprises – which was mirrored by an improved sentiment towards US assets - and especially following the change in seasonal adjustment factors for data referring to January 2012 onwards – as published by the US Department of Commerce on Wednesday – the near-term risks for negative data surprises have increased substantially. I expect US economic data referring to January and especially to February to disappoint on average! However, it does not alter the medium term trajectory of the US economy nor change my positive view on Eurozone assets (see also 2009 all over again? dated January 23). Rather it should see speculation about QE3 in the US intensifying.

I have stated on several occasions that I think the seasonality of the US economy should have decreased but the actual seasonal factors used to adjust the raw-data have increased (see for example: Growing probability of positive US data surprises dated May 31 2011). Since the onset of the last recession in late 2007 the US economy has lost several million in manufacturing and in construction (approx. 2mln each). On the other side, employment in sectors such as healthcare (+1,5mln) has increased. While the former are highly seasonal, the latter is not. As a result, the seasonality of the US economy should have decreased. However, the seasonal factors which have been used in 2010 and 2011 assumed that the seasonality of the US economy has rather increased! The reason for this is that the seasonal factors are calculated via statistically analysing historical data. The sharp slump in GDP following the bust of Lehman Brothers took place in autumn and winter. Given that this period is the seasonally weak period of the year anyhow (with January being the weakest month), the statistical techniques resulted in larger statistical factors. This can be seen in the chart below which shows the seasonal factors used to adjust the raw data of the ISM manufacturing index.

Seasonal Factors used for the US manufacturing ISM index: higher seasonality in 2011?

Source: ISM, ResearchAhead

The factors for 2007 are shown in blue, those for 2011 in grey and the difference between the two in red. As can be seen, in 2011 the period from November to March (i.e. those months where the financial crisis in 2008/2009 led to a stand-still of global trade) was assumed to be significantly weaker than in 2007 (the seasonal factors are lower). On the other side, the seasonal factors for April-August assumed that the economy would be showing more momentum in 2011 than in 2007. Hence, the seasonal factors assumed in 2011 (and 2010) that the US economy’s seasonality increased significantly. As a result, the published seasonally adjusted data painted too positive a picture for data relating to the November-March period and too negative a picture for the April-August period. I think it is no coincidence that the US stock market topped out in spring 2010 and 2011, i.e. just as the period of artificially positive data came to an end. Furthermore during both years it bottomed in summer, i.e. just as the period of artificially weak data was about to end.

However, yesterday, the US Department of Commerce published the seasonal factors to be used for the calculation of the manufacturing and non-manufacturing ISM indexes in 2012. It stated that: “In response to concerns that the unusually large declines in autumn 2008 associated with the recent recession that may not have been adequately handled with default settings, this year the Department of Commerce used lower thresholds (critical values) for detecting outliers. “

Seasonal Factors used for the US manufacturing ISM index: lower seasonality in 2012

Source: ISM, ResearchAhead

As a result, the seasonal factors which are to be used for this year’s ISM releases have been changed materially as the chart above shows which compares the factors for 2011 and 2012. Especially the seasonal factors relating to January-March have been increased significantly (and those for May-October lowered significantly). In turn, the seasonal factors have moved closer again to where they were before the financial crisis.
The result though is significant. For today’s release of the January ISM index, the difference between the 2011 seasonal factors and the 2012 numbers amounts to approx. 0,6 points in the headline number (i.e. the 2012 number should be 0,6 points lower, all else equal) and a full 2 points for the February release! The difference is the largest for the New Orders component where the seasonal factor rose from 0,944 in 2011 to 0,999 in 2012 which depresses this sub-component by approx. 3 points! For the non-manufacturing index, the January 2012 numbers should be 1 point lower than in 2011 purely due to the change in the seasonal factors.
Given that US economic data has surprised positively in the second half of 2011 (see chart below for the Citigroup US economic surprises index), sentiment towards US risky assets and economic forecasts have improved also. However, coupled with the changes in the seasonal factors, this should lead to a significant downside risk in economic data over the next weeks, starting with data relating to January and intensifying for data relating to February!

US Citigroup Economic Surprise Index: multi-months positive surprises should by now be reflected in improved forecasts

Source: Bloomberg

2009 all over again?

2012-01-23T11:35:00.000+01:00

I am convinced that the global economy - ever since the financial crisis started in 2007 and put in motion a deleveraging wave - is going through a multi-year cycle which looks in general like this: Weak growth --> low inflation --> Liquidity glut (emanating from the central banks in the deleveraging economies) --> higher prices for financial assets --> macro-economic stabilisation --> higher commodity prices --> higher inflation -->tighter monetary policy --> lower prices for financial assets --> lower growth --> low inflation.
2010 was the year where financial asset prices imploded and growth/inflation weakened but I think that we are now again in an environment where the liquidity glut intensifies (mainly due to the ECB's 3y LTRO) which leads to a longer-lasting rebound in prices for equities, (risky) bonds as well as commodities.

The financial crisis (especially following the Lehman bankruptcy in 2008) pressured prices for financial and real assets sharply lower and led to a severe global recession. Inflation fell significantly and in turn global central banks coul,d orchestrate a massive easing wave and liquidity injections. This led a rebound in prices for equities, (risky) bonds and commodities which - coupled with significant fiscal easing steps - helped also the economy to recover. But mainly due to higher commodity prices, this also led to higher inflation rates which was mirrored by a wave of central bank tightening in 2010 and 2011 (mainly in emerging market economies but also in the Eurozone). This in turn weakened growth and - also via a tighter liquidity environment in the Eurozone - intensified the Eurozone sovereign and banking crises. However, as growth weakened substantially and prices for equities, (risky) bonds and commodities fell markedly, inflation started to fall back again, allowing a growing number of central banks to start easing monetary policy. Furthermore, as in late 2008/2009, the central banks at the epicentre of the financial crisis (this time the ECB) injected an unprecedented amount of liquidity into the system.
I have mentioned previously that the ECB's 3y LTROs are leading to a liquidity glut in the Eurozone (see: The Eurozone liquidity glut dated Jan 17) which should put downward pressure on the external value of the Euro and peripheral/credit bond spreads while it strengthens banks' balance sheets. As a sidenote, the ongoing high level of usage of the ECB's deposit facility usage is not a sign of the stress in the banking sector. If the ECB's support measures create excess liquidity then one way or the other it has to find its way back to the ECB (The liquidity does not go away). More important is whether this liquidity is being hoarded by the banks (a sign of stress) or is floating around the system (and drives asset prices higher as this happens). Last year, banks used the ECB's liquidity operations to hoard cash. However, as Draghi has mentioned at the last press conference, now the banks which make heavy usage of the 3y LTRO are not the ones which deposit liquidity at the deposit facility. Hence, the liquidity has started to float around the system and we are in the midst of a liquidity glut environment!
As a result, I am of the opinion that 2012 could well see a (partial) re-run of 2009, the year where financial markets recovered substantially from very depressed levels and growth turned the corner. I expect financial markets to continue pricing out the systemic risk of a Eurozone collapse/wave of sovereign and bank defaults given that the 3y unlimited liquidity provision keeps the banks liquid and increases the incentives to set up carry trades which in turn also keeps the sovereigns liquid. As this happens, the financial sector should outperform (i.e. bank shares should outperform vs. the rest of the market as should bank bonds). In a second phase, the economic prospects should improve (as sentiment data recovers) which should then take cyclicals higher.

In this environment, especially, the valuation of the Eurozone banking sector appears still at too low levels. The chart below shows the price-book ratio of the Stoxx600 Bank index as well as the index itself. The price-book ratio fell to around 0,5 in early 2009 before recovering to approx. 1,2 in late 2009 and trading around 1 until early 2011. Last year it fell again towards 0,5 and is currently around 0,6. In order to justify these levels, the market assumes that banks either have to take significant losses (which lowers the book-equity) or have to raise new equity at values significantly below book-equity. The first appears unlikely in the short term, given that prices for peripheral bonds (where banks hold a significant exposure) have risen substantially over the past weeks. With the liquidity glut significantly reducing the probability of a default wave, it is difficult to see the banks suffering from such big losses which would lower their book equity. Furthermore, the banks had to present how they plan to fulfil the capital requirements as defined by the latest EBA stress tests until last week and further large rounds of external financing - which dilutes existing shareholders - should be limited. Finally, the ECB essentially injects a two-digit billion Euro amount into bank equity over the next three years without diluting existing shareholders. Following the collapse of Lehman Brothers, markets for bank bonds were shut and banks issued bonds with state guarantees. These bonds had a 3-year maturity (and are expiring this year) and carried an average coupon of 3.5%. Adding to that a fee for the state guarantee, the cost of this funding should have amounted to approx. 4%. If we take this 4% as an average funding cost, then a Eur 500bn take-up at the LTRO for 1% would result in a reduction in financing costs (and hence an improvement in the P&L) of EUR45bn over the next 3 years. In turn, I think that the recovery in prices for financial shares (as well as bank bonds) has further to run.

Eurozone banks still appear undervalued

Source: Bloomberg

The Eurozone liquidity glut

2012-01-17T11:23:00.000+01:00

The ECB is orchestrating a Eurozone liquidity glut on an unprecedented scale via their measures to support bank liquidity. It helps the banks to remain liquid and improve their net-interest margin (which in turn helps profitability). Additionally, it also lowers the pain from the significant amount of bank bond redemptions this year and eases the need for banks to deleverage. Furthermore, it has the effect of driving down the external value of the Euro (thereby helping the Eurozone to gain market share and the weak peripheral economies to regain competitiveness at least vs. the non-Eurozone countries) and depressing short-end yields across the credit spectre (thereby easing the pain for the weak peripheral economies and helping the sovereigns to place their new issues). Finally, the resulting higher prices for peripheral bonds strengthens banks' balance sheets. Overall, I think that the second 3y LTRO at the end of February could see a massive take-up and that the ECB's measures are still underappreciated in the market.

I already mentioned in The ECB's XMas Present dated Dec. 19 that I regard the new 3y LTRO by the ECB as an "extremely positive development" and that I expect a huge take-up in the two announced LTROs. In the meantime, the first LTRO took place which resulted in a take-up of EUR 489bn and a net liquidity injection of a bit more than EUR 200bn. Additionally, judging from last week's press conference, ECB president Draghi seemed relaxed about this result and hence we should not expect the ECB to tighten their stance on the upcoming second LTRO at the end of February. For this liquidity operation, I expect an even larger take-up than in December. The easing of the collateral rules which now allow to pledge bank loans meeting specific criteria were not in effect in December given that the national central banks did not yet produce the necessary paperwork. However, Eurozone banks hold approx. EUR7trn in bank loans out of which probably around a fourth to a third might be eligible. Given the very low interest rate on the LTRO of currently 1%, banks don't seem to be able to get cheaper financing of such rather illiquid assets elsewhere. Hence, it makes a lot of sense to fund as much as possible via the upcoming LTRO in order to a) secure financing b) lower financing costs and c) free higher-quality collateral to be used for other transactions. The direct effects will be that the bank system liquidity is secured and the funding pressures on the Eurozone credit markets will ease.
There are approx. EUR 800bn in bank bonds (senior & covered bonds as well as government guaranteed bank bonds) coming to maturity this year. Out of which almost EUR 200bn are government guaranteed paper which were originally issued following the bankruptcy of Lehman Brothers and carried an average coupon of 3.5%. Hence, the effect on the net-interest-margin of Eurozone banks and thus P&L should be substantial. Assuming a total take-up in both operations of EUR700bn (i.e. assuming a net liquidity injection of EUR500bn at the end-of-February LTRO) and using the government-guaranteed cost of funding of 3,5% (which clearly underestimates the true savings in financing costs) suggests a reduction in financing costs of 2,5% p.a. which would equal EUR17.5bn p.a. or approx. EUR50bn over the life of the 3y LTROs.

For the markets, this should have several effects:
a) The external value of the Euro should continue to fall given the rising Euro-glut. The chart below shows the ECB's balance sheet vs. the EUR-USD exchange rate as well as vs. the trade-weighted Euro. As can be seen, during periods of a rising ECB balance sheet (mainly on the back of the liquidity support measures for the banking system), the Euro was in a downward trend which should remain the case. A weaker Euro would also help the Eurozone export sectors to gain market share.

ECB balance sheet vs. external Euro value

Source: Bloomberg, ResearchAhead

b) Short-end carry products should be in demand. Despite the recent fall in yields, the average yield of 3y Belgium/Italy/Spain government bonds is still around 3.4%, i.e. banks can buy these bonds in the secondary market, finance it via the ECB and earn 2.4% p.a. In turn, this should be seen as the main reason why peripheral spreads have tightened markedly over the past weeks.

2-10y Box spreads: Curve normalisation following announcement of 3y LTRO

Source: Bloomberg

c) The higher valuation of government bonds supports bank balance sheets. Given that Eurozone banks hold a significant amount of government bonds on their balance sheets, the fall in government bond prices has weakened bank balance sheets substantially and hence the sovereign crisis also resulted in a banking crisis. Now, however, as sovereign bond prices are rising (given that banks have come back on the buying side), the banking sector balance sheets appear stronger again.

The ECB is orchestrating an unprecedented Euro glut which supports the banks and sovereigns alike. The demand for funds at the second 3y LTRO at the end of February should be very large and its impact should not be underestimated!

The ECB's XMas Present

2011-12-19T12:58:00.000+01:00

I regard the new 3y Tender by the ECB (first one to be conducted thisWednesday and the next one in February) as an extremely positive development.The unlimited fixed-rate tender provides the banks with the option to redeemall or part of the acquired liquidity in 1 years’ time. Hence, banks keepflexibility over their collateral usage. More importantly, the ECB easedcollateral standards (ABS down to A rating are eligible as are loans to smalland medium sized enterprises).

I see the following main advantages of this tender:
1. During the next year a significant amount of bank bonds will reach maturity (around EUR 800bn).Approximately one quarter of this are government guaranteed bonds which wereissued after the Lehman bankruptcy and carried an original maturity of around 3years. Currently, banks face a very difficult environment to issue bonds (evenfor covered bonds) and most likely would need to revert to a new scheme ofgovernment guarantees. However, in those countries where even the sovereignsface a challenging environment to issue bonds, government guarantees wouldprovide only a limited insurance function. However, as banks can now fundthemselves for 3 years at 1%, this ECB tender should go a long way in easingthe refinancing burden during 2012. It secures medium-term bank liquidity at avery low rate. Furthermore, it eases the pressure for governments as the likelysize of needed government guarantees drops. Hence, via this tender, theliquidity provision for banks via sovereigns is being substituted by the ECB!
2. Banks can fund illiquid SME loans at extremely favourable conditions (1% at present). Thedrawback though is that the necessary legal paperwork so far has apparently notbeen finished yet and hence it is not clear whether this applies already forthis week’s tender or only for the next one in February. This has severaleffects. For one, banks don’t need to fund these loans anymore in unsecuredmarkets. Hence, it takes the pressure of unsecured funding markets.Furthermore, it increases the positive carry of the bank loan book as fundingcosts drop sharply. Finally, it frees higher-quality collateral which banks canuse for other secured transactions.
3. The refinancing costs for Eurozone banks should fall sharply (as they fund an increasing part oftheir balance sheet at 1%). This increases realized margins and should help torestore equity over time, improving bank solvability.

I am convinced that the easing of banks’ funding pain is also behind the improvement in the short-enddynamics of the Eurozone periphery over the past week. Especially for small andmidsized banks which a) are not part of the EBAs Stress Tests and b) hold largeshares of SME loans, this tender should significantly reduce the need todeleverage and on the margin improve the demand for (domestic) governmentbonds, especially those that trade above 1% yields and mature in around 1-3years.
Overall, I expect the two tenders to result in a very large take-up by Eurozone banks. However, it islikely that the February tender will be significantly larger given that so farthe necessary legal paperwork for accepting bank loans seems not to befinalised yet. However, I do not think that this action is enough to break theadverse feedback loop and the real test will happen from around mid-Januaryonwards, when the sovereign funding spree starts in earnest.

I wish all my readers a happy festive season and a good start for 2012!

Financial Repression

2011-12-15T11:10:00.001+01:00

I have been advocating that the ECB should be buying peripheral government bonds for quite some time (see Monetary easing in the wrong places or will the real ECB please stand up? dated 17 November 2010), however, that does not seem to be forthcoming. I have co-authored a research piece which proposes a different solution. It is based on the following:

1. There are no good solutions left

2. We are in the midst of a devastating debt-deflation spiral. While such a downward spiral starts with an insolvent borrower (in our case Greece) it also affects solvent borrowers and via the negative feedback loop (higher yields = higher deficit/lower growth = lower solvability = lower rating =higher yields) it ultimately destroys even the healthiest borrower (for every frequent borrower, there is a level of yield which it can not afford for a prolonged period of time).

3. What directly follows from the above is that we are in a state of multiple equilibria. One equilibria is the one where we are headed to now which will destroy all the sovereign borrowers of the Eurozone/the Euro. Another equilibria is if government bond yields can be lowered enough to restore fiscal solvability (via lower yields) and improve Eurozone bank balance sheets (via higher prices for government bonds).

4. Hence we need to find a very large buyer for Eurozone government bonds. If the ECB does not want to buy and the EFSF is not large enough (and remember as the EFSF has no banking licence, hence it needs to issue bonds itself to get cash before it can buy government bonds in the secondary market), then our solution is to use financial repression. More specifically, we would force banks to substantially increase their liquidity buffers over the next four years with only Eurozone public sector exposure allowed in this liquidity buffer.

If complemented by a stability union, the prevention of further voluntary/forced haircuts on government bonds as well as the exclusion of Eurozone government bonds from further stress tests by the EBA then we are convinced that this will be able to break the debt-deflation spiral.

The publication can be found here:
English: Enhanced Liquidity Buffer Framework
Deutsch: Rahmenvereinbarung über erhöhte Liquiditätspuffer

A fundamentally more dovish ECB

2011-11-03T17:30:00.000+01:00

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?

2011-10-27T10:09:00.000+02:00

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?

2011-09-15T15:34:00.001+02:00

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?

2011-08-10T10:29:00.005+02:00

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?

2011-08-09T10:56:00.003+02:00

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

2011-08-02T11:14:00.010+02:00

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

2011-07-04T18:44:00.011+02:00

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

2011-06-29T10:23:00.008+02:00

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

2011-06-10T10:01:00.008+02:00

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

2011-05-31T12:37:00.005+02:00

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?

2011-05-25T11:00:00.006+02:00

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

2011-05-16T14:47:00.006+02:00

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

2011-05-04T10:48:00.005+02:00

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

2011-04-29T11:35:00.006+02:00

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

2011-04-05T09:10:00.005+02:00

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

2011-03-25T14:25:00.004+01:00

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?

2011-03-07T12:36:00.008+01:00

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

2011-03-03T14:44:00.004+01:00

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

2011-02-22T11:35:00.006+01:00

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

2011-02-02T11:05:00.004+01:00

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

2011-01-28T11:03:00.006+01:00

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

2011-01-25T10:11:00.009+01:00

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

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

Source: Bloomberg

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

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

Source: DeStatis

Do they finally get it?

2011-01-12T10:02:00.009+01:00

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

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

Source: Bloomberg

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

Merry XMas and a Happy New Year

2010-12-14T12:11:00.003+01:00

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

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

Just Blame Germany

2010-12-08T13:03:00.003+01:00

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

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

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

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

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

Finally some good news

2010-12-01T12:05:00.003+01:00

Some days ago Mr. Weber, the arch-hawk and president of the German Bundesbank, hinted that the European Financial Stability Facility could be increased in size in order to combat the woes in the Eurozone periphery. Furthermore Mr. Trichet, the president of the ECB, stated yesterday at a hearing in the European Parliament that "We will see what we decide" when referring to the ECB's bond buying program. Additionally, he suggested that markets would be underestimating EU government's determination to safeguard the Eurozone.
The statements by both, Mr. Weber and Mr. Trichet, are important. They suggest that the ECB now sees the need for more action in order to stabilise peripheral bond markets/economies, even though they will likely continue to disagree on the means to use. Mr. Weber seems to be preferring actions by the EU (i.e. an increase in the EFSF) while keeping the ECB out of this area whereas Mr. Trichet understands that the ECB has to and can provide significant support for financial stability.
I mentioned previously that I favor a significant quantitative easing program by the ECB (see Monetary easing in the wrong places or will the real ECB please stand up dated 17th November) - which could be put into practice straight away - and should be followed later on by joint Eurobond issuance for parts of the sovereign debt (i.e. up to 60% of GDP and up to a 3% deficit per year for each country) as mentioned in the last blog post.
A massive buying of peripheral bonds by the ECB would a) directly reduce peripheral bond yields and with that help to keep fiscal deficits in check and promote debt sustainability b) provide an effective floor for bond prices and hence increase incentives for investors to buy these bonds as well which renders financing of maturing debts/deficits for the peripheral countries easier. Given the prohibitively high interest rates on peripheral bonds, the monetary environment in the affected countries is currently very restrictive. Coupled with the ongoing fiscal tightening programs, this means that deflationary pressures have been rising. A significant reduction in these yields would just render the monetary environment less restrictive without causing inflationary risks.
Judging from Mr. Webers and Mr. Trichets comments, the discussion within the ECB about larger bond buying programme seems to be taking place at the moment and there is a good chance we will see some announcements being made at tomorrow's press conference. I expect some new measures (i.e. increased buying of peripheral bonds) but not to the extent which will really turn things around for good. Rather we are likely to get a timid response by the ECB, just enough to improve sentiment towards risky assets in general in the short term but not enough to provide a real lasting solution.

Still, in conjunction with an improving macro-environment in the US (the next weeks/months promise to see a slight growth rebound), the stage might be set for a year-end rally in equities.

Watching the dominos fall

2010-11-26T10:20:00.004+01:00

The adverse feedback loop (higher yields=weaker economy =higher default risk=higher yields) remains in full swing in the Eurozone periphery and the dominos are falling one after the other. If nothing changes, then Portugal will have to get a bail-out and after that Spain. With Spain, the capacity of the EFSF would be used up but the capacity of the market to cause more havoc will remain as the focus is likely to shift to Belgium and then Italy. At the latest with a potential bail-out of Spain, something has to happen. What are the options for the Eurozone?

A) Sovereign default: a sovereign default, be it for Greece, Ireland or any other Eurozone member would be disastrous at present. Should any sovereign default on its bond obligations, then the downward spiral would intensify even further and affect even more countries. Furthermore, the banking sectors of the core countries would be affected significantly - amid their holdings of peripheral debts - threatening the core economies. Given the adversity of this scenario, I am convinced that European authorities/politicians will do everything they can to prevent it from happening.
B) Significant quantitative easing by the ECB: As mentioned in my last blog post (Will the real ECB please stand up?), the monetary transmission mechanism in the Eurozone is not working properly. Should the ECB engage in massive quantitative easing (several hundred billions of peripheral bond buying), it could change the dynamics significantly. The ECB bond buying would depress peripheral bond yields sharply and help these sovereigns to continue financing its debt without needing a bail-out. Given such a massive ECB bond buying which breaks the adverse feedback loop, private investors could also move back on the buying side. This could be implemented very easily but the consensus within the ECB for such a course of action is not there (yet).
C) Joint Eurobond issuance. A fairly sensible solution would be to start with joint issuance. A new central agency would issue Eurobonds. Each country could finance up to the criteria set in the stability pact, i.e. up to a maximum outstanding amount of 60% relative to GDP and up to a maximum new issuance each year of 3% of GDP. Any financing needs exceeding these limits would continue to be financed via national bonds (i.e. Bunds, BTPs, BONOs etc.) which, however, would be subordinate to the Eurobonds. Given the much more limited outstanding amounts of the new national bonds, default on these bonds becomes more likely as the risk of contagion and the risk of a systemic financial sector crisis would be much lower. The credit risk and liquidity of these national bonds would be lower and hence yields higher, much higher for the peripheral countries. As a result, the market would continue to differentiate between issuers and hence there would be very strong incentives for each country to remain within the stability pact criteria (much stronger incentives than there were in the past). Additionally, if Eurobond issuance were to start now, the peripheral countries could refinance all their maturing debts and it would take several years before the 60% limit would be reached. The financing via national bonds would be very limited initially (only the part of the deficit exceeding 3%) and could probably be done - at high rates - with short maturity bonds. The implementation, though, seems difficult and there is no political will to engage in such a course of action (yet).
D) A doubling up of the EFSF: this would just prolong the current downward spiral. It would not break the adverse feedback loop (higher yields-weaker economy-higher default risk-higher yields) and the bail-outs would likely continue. However, it would still not be enough to deal with a potential bail-out of Italy. Such a doubling up per se would not offer a lasting solution. Alternatively, a doubling up + ECB buying to a much higher degree where a total of approx. EUR 2trn could be provided would be a different thing as it would guarantee financing and would reduce market rates.
E) A Eurozone break-up. Should the Eurozone break up, the most likely course of action would be for a formation of two separate currency areas (Euro north and Euro south). For a single country to leave, the economic costs would be almost unbearable. A weak country would lose all access to financial markets, could not service its EUR-denominated debts and would need to default. A strong country would see its new currency skyrocket, threatening to kill exports and the banking sector (because they hold a lot of assets denominated in the now weaker EUR). The only half-way realistic scenario would be for the northern block (Germany, Austria, Finland, Netherlands, Luxembourg, potentially Belgium) to form a new currency area which would limit the appreciation effects/reduce the loss of exports/devaluation of banking assets. On the other side a weak country could only leave as a group as well (Greece together with Spain, Portugal, Italy and maybe France) to form a new larger group with a meaningful internal economic and financial market which is still able to attract some foreign capital. However, for such a separation there would need to be a very strong political will (given the super high costs involved) and in turn a democratic legitimation to engage in such a course of action. But for such political movements to form, it needs time, i.e. some years.

Overall, amid the complexity, the costs involved and potential time it needs, a Eurozone break-up remains highly unlikely. Rather, the current path will continue to be taken up until a large country (probably Spain) needs a bail-out and the capacity of the EFSF is being used up. At that stage the political will to start with joint Eurobond issuance or the consensus within the ECB to engage in massive quantitative easing are likely to form, i.e. I think that the most likely scenario is the one of ECB QE (done in conjunction with a topping up in the EFSF), followed by joint Eurobond issuance. Together, I would assign these scenarios a probability of around 60-70%. Up to that point we can continue to watch the dominos fall.

Monetary easing in the wrong places or will the real ECB please stand up?

2010-11-17T13:44:00.006+01:00

It should have been the ECB and not the US Fed which embarks on another round of quantiative easing.

The US Federal Reserve has started their second round of Quantitative Easing which they announced at their last meeting. The first round of QE (and credit easing) was conducted in the wake of the Lehman bankruptcy. At that stage credit yields were rising despite a lower Fed funds rate and lower short-end UST yields (see chart below). These rising yields led to a further worsening of the fundamental situation and increased the risk of corporate bankruptcy which in turn led to higher yields: the negative feedback loop. As a result, the credit/quantitative easing efforts by the US Fed had a significant impact on market pricing and with that on the economy.

US: Negative feedback loop in 2008/09, but not now

Source: Bloomberg, St. Louis Federal Reserve

Now, however, neither the level of yields nor the availability of liquidity for the banking sector is holding back the economy. Bond yields have been at historic lows (such as for short-term yields) or at least close (at the longer end). Furthermore, credit-related yields are also at historic low levels, be it in nominal as well as in real terms. Additionally, banks continue to hold a significant amount of excess reserves. In turn, the effect of additional liquidity injection by the US Fed’s Treasury purchases on the real economy in the US should be limited. Rather, the economy is suffering from a lack of aggregate demand which could be eased by additional fiscal spending. But for that the political will is lacking. Overall, despite the additional monetary easing, the outlook for the US economy remains for an extended period of limited growth, but I see only a low risk for a double-dip in the next few quarters. Winter promises to see a slight rebound from the weaker numbers of the last months.

In the Eurozone, however, the ECB is keen to continue its exit from the exceptional liquidity support measures. This is also evident in the rising money-market rates. Several prominent members of the ECB/national Eurozone central banks also feel at unease with the historic low ECB repo rate.
Indeed, the overall Eurozone growth environment with growth at a non-annualised 0.4% in Q3 and yoy inflation currently running around 1.9% (1.1% for the core rate) suggests that it could withstand a somewhat less accommodative monetary policy environment. However, this is not how things work in the Eurozone. The Eurozone is a combination of unequal economies with the outperforming economies enjoying the most accommodative monetary environment and the underperforming economies suffering from the most restrictive monetary environment.
Most notably Germany could do with higher yields. It is one of my long-held believes that Germany is at the start of a multi-year high-growth period. Given that Germany has the lowest nominal bond yields, it has currently also the lowest real yields and in conjunction with a healthy growth environment, it is relatively easy for corporates and households to access credit. As Germany is outperforming, its monetary environment becomes even more accommodative, reinforcing the upswing.

Eurozone: Negative fedback loop is still alive (10y yields)

Source: Bloomberg

On the other side, for example Ireland has much higher nominal yields and given that it suffers from deflation (yoy inflation stood at -0.8% in October), has extremely high real yields. Furthermore, amid the ongoing deep recession, credit is much more difficult to come by for corporates and households. Both, the restrictive credit environment and the highly restrictive level of real yields are reinforcing the deleveraging process and thereby acting to slow down the economy further. This is debt-deflation at its best and results in a downward spiral with the worsening fundamental environment deferring investors, thereby leading to higher yields and with that to ever stronger deleveraging pressures and so on.
For the ECB, this poses indeed a difficult task: The largest economy as well as the Eurozone average would demand a less accommodative environment but the peripheral countries need a more accommodative environment. With the help of their traditional rate setting, they only can lower the level of core bond yields. For the group of peripheral countries where the negative feedback loop is alive, the low repo rate environment has limited effects. If the ECB were up to a more activist stance, it could hike the repo rate but at the same time engage in massive credit (sterilised) or quantitative easing (non-sterilised) via buying of peripheral bonds. With that it would achieve both goals: a somewhat less accommodative environment for the economically sound and well-growing countries but a less restrictive stance for the periphery. Furthermore, the ECB’s support for secondary bond prices would also promote private sector demand for these instruments and limit contagion for other peripheral countries.

So far, the ECB bond buying has been very limited and was thereby not able to break the negative feedback loop. Unfortunately, I only see a low probability that the ECB will seriously step up its bond buying efforts given the prominent adversaries of the existing low-scale buying. Rather it seems likely that we continue facing a re-active ECB which will lead to an even easier monetary environment for the north-east but not the periphery. It should not be the US Fed which is engaging on another round of quantitative easing, it should be the ECB! But as it isn’t, the peripheral countries will continue to suffer from a very restrictive monetary policy environment. For the time being, we can continue to watch the Irish domino fall and once the bail-out has been announced, the focus can shift to Portugal and at a later stage to Spain.

A disintegrating Eurozone?

2010-11-10T11:06:00.008+01:00

One disturbing development within the Eurozone is the reduction in internal trade flows as well as the domestication of some debt markets.

This FT article states that "Foreign holdings of Portuguese and Irish bonds fell to 65% of total debt at the end of the second quarter from 85% in 2009. They fell to 55% from 70% in Greece and to 38% from 43% in Spain during the same period." As foreigners stopped buying the bonds of these countries, domestic institutions (mostly banks, but apparently also pension funds and insurance companies) were buying them.
As a result holdings by other countries of these bonds fell. The table below shows the foreign assets of the German banking sector of other Eurozone countries at the end of 2008 as well as in September this year and the %-changes. In combination, German banks reduced their holdings of assets in Greece, Ireland, Portugal and Spain by more than 15% whereas they increased the assets relating to neighbouring Eurozone countries by almost 5%. Furthermore, they also decreased the assets of the other southern European countries, most notably Italy.

German banks' foreign assets holdings (in €mln)

	Dec 2008	Sep 10	%-change
Belgium	25.392	31.700	20%
Finland	8.401	8.713	4%
France	152.400	171.338	11%
Greece	28.550	29.044	2%
Ireland	188.051	157.519	-19%
Italy	144.257	115.338	-25%
Luxembourg	191.005	189.383	-1%
Malta	7.643	7.154	-7%
Netherlands	118.075	120.170	2%
Austria	76.688	78.098	2%
Portugal	27.859	25.665	-9%
Slowakia	2.727	2.809	3%
Slovenia	4.425	3.593	-23%
Spain	176.909	149.762	-18%
Cyprus	8.017	7.021	-14%

SP,GR,IR,PO	421.369	361.990	-16%
AT,NL,FR,BE,LU	563.560	590.689	5%
IT,FI,SL,SL,CY,MA	175.470	144.628	-21%
Total	1.160.399	1.097.307	-6%

Source: German Bundesbank

But also in terms of trade flows, a similar picture emerges. The table below shows the German exports and imports from June-Aug 2010 compared to the same period in 2007. Exports to Portugal, Ireland, Greece and Spain decreased by almost one fourth, highlighting the weak state of these economies. However, imports from these countries also dropped by a significant 7%. In contrast, German exports to its neighbouring Eurozone countries (France, Netherlands, Austria, Belgium, Luxembourg) increased slightly by 2% whereas imports from neighoubirng countries increased by a significant 6%. In between is the group of non-SGIP/non-neighbouring Eurozone countries (Italy, Finland, Slovenia, Slovakia, Malta, Cyprus) where Germany saw its exports drop by almost 8% and imports drop by 3%. Interesting is also the development of German trade flows vs. its non-Eurozone neighbours (Poland, Denmark, Czech Republic, Switzerland, Liechtenstein) which have increased significantly vs. 2007.

German imports and exports Jun-Aug 2010 in €bn & %-changes vs. same period 2007

Source: German Statistics Office, Research Ahead

Yes, Germany is exporting its improved business environment via higher imports, but mostly to its neighbouring countries and less to the fiscally challenged SGIP.
Overall, the combination of the changes in cross-border holdings of financial assets as well as in the composition of trade flows suggests that the group of fiscsally challenged countries - Spain, Greec, Ireland, Portugal - is seeing its economic ties with the rest of the Eurozone weaken significantly, i.e. to some degree they have been disintegrating from the rest of the Eurozone. As a result, so far they could not profit that much from the economic rebound in the north-eastern Eurozone countries.
On the other side, the already rather strong economic integration of the north-eastern Eurozone countries is intensifying further.
Should these economic developments run further - disintegration of the fiscally challenged economies from the rest of the Eurozone, intensifying integration of the economically stronger north-eastern countries - political realities could start to mirror these developments via the formation of a north-eastern political club with a weakening of the will for ongoing support measures to the rest of the Eurozone.

German Wirtschaftswunder revisited

2010-11-03T09:39:00.003+01:00

I have been arguing for a long time that the multi-year outlook for the German economy is extremely positive (see for example There is more to celebrate for Germany from Nov last year or German Wirtschaftswunder 2.0 from May this year). In the meantime, economic data out of Germany has surprised most economists and investors. While growth projections have been revised upwards, I remain convinced that the outlook for the German economy (and thus for German real and financial assets) is by far much more favorable.

There are various reasons why this is the case:
a) German corporates have become extremely competitive over the past decade. During the first years of EMU they had to largely regain competitiveness vs. the rest of the Eurozone as Germany locked in an uncompetitive exchange rate when the euro was formed and German corporates were heavily in financial deficit following the debt-financed M&A boom during the dot-com bubble. In turn, at the start of the last decade German corporates had to restructure (i.e. cut costs - especially via headcount reduction in Germany and offshoring/outsourcing) to regain cost competitiveness and reduce the financial deficit. Unfortunately, as Germany regained internal competitiveness during the last decade, the external value of the euro soared, especially vs. key competititors such as Japan. However, over the past 2 years, the euro has lost altitude - again especially vs. key competitors - and German corporates for the first time since the start of EMU are competitive on an intra-Eurozone and on an extra-Eurozone basis. Additionally, German corporates on aggregate have moved from a financial deficit into a financial surplus.

b) German households have been burdened over the past decade by the restructuring of the corporate sector and the numerous reforms by the state of amongst others the labour market, the unemployment benefits as well as the pension systems. In combination they had the effect of rising the financial risks carried by each individual (via lower job security and lower social security), temporarily increasing unemployment and reducing wage growth. All this put downward pressure on the sum of wages earned and upward pressure on the German savings ratio, in turn creating an environment of weak domestic demand. However, now the sum of wages earned is increasing (as unemployment dropped sharply and we are likely to enter an upcycle in wage growth) while no more significant structural reforms are on the agenda. In turn, the outlook for consumption growth has become favorable as well for the first time since the start of EMU.

c) The Germans state was forced to carry through numerous structural reforms as well as several rounds of fiscal tightening to reduce the structural fiscal deficit. However, at present the situation of German state finances is relatively healthy and in turn the need to carry through fiscal tightening measures is limited. The German government decided to engage on a 4-year tightening programme, but on average the tightening amounts to only approx. 0.25% of GDP per year. Furthermore, as the economy is doing better than anticipated, fiscal deficits are undershooting the projected levels by a significant margin.

d) At the start of EMU, Germany had a high price level which combined with weak economic developments resulted in below-average inflation and thus in above-average real yields, further restraining the economy. Now, however, the German economy is roaring ahead which should lead to inflation being more in-line with the Eurozonea average. Additionally, intra-Eurozone sovereign spreads are very high and as a result, Germany is enjoying the lowest real yields within the Eurozone. Finally, as the outlook for the German economy is favorable, credit conditions are easing. As a result, for the first time since the start of EMU, Germany enjoys a very accommodative monetary environment.

What is more, all of these factors re-inforce each other. While at the beginning of the last decade this lead to a vicious circle whereby weakness in the corporate sector, the household sector, a restrictive fiscal and monetary environment all reinforced each other, we are now just at the beginning of a virtuous circle.
The strength in the corporate sector is leading to more employment and with that wage and consumption growth. The outlook for the domestic economy is thereby improving, leading corporates to invest more and banks to provide more funds (as the perceived credit risk is lowered). The fiscal deficit is reduced which reduces the need for fiscal tightening/opens the door for fiscal easing. Domestic inflation picks up which - given that Germany outperforms the rest of EMU - leads to lower real yields, further promoting more investments and a lower savings ratio. Within the monetary union if a country starts to outperform in economic terms, its monetary environment becomes even more accommodative not less, further reinforcing the upswing.
Given the favorable starting point for Germany in terms of corporate competitiveness and low private sector indebtedness such a virtuous circle can last for years without leading to cost disadvantages and/or over-indebtedness.

We are just at the start of this virtuous circle where the drop in unemployment - due to the export led growth rebound - starts to fuel wage gains and coupled with low real yields promotes a reduction in the savings ratio. This will create an increasingly favorable environment for domestic demand and lead to the next wave in growth. I remain convinced that Germany will show above trend growth for the next 3-5 years. While there will be ups and downs in quarterly growth numbers, I continue to look for growth to average around 2.5-3%.

Blog Reactivation

2010-10-22T11:15:00.003+02:00

I hope to become more active again with this blog from now on. Please apologize for the temporary blackout period but I have been busy with other ventures. In the meantime I also updated my website www.researchahead.com (English version) and www.researchahead.de (German version).

Any feedback appreciated.

All Good Things Come to an End

2010-10-22T10:47:00.009+02:00

I remain sceptical with respect to the economic effects of QE2. Subdued growth is here to stay for a prolonged period in the US as households will deleverage further whereas the government sector has to rein in its deficits over the medium term. Additionally, I don’t expect inflationary pressures to grow meaningfully over the foreseeable future. There is ample spare capacity as can be seen for example by the high unemployment rate and with muted Growth this is unlikely to change soon. Furthermore, the money being created by the next round of QE will likely lead to another significant rise in banks’ excess reserves and in turn not hit the real economy. As a result, there will continue to be too many goods being chased by too little money. The main effect of QE will be to support asset prices/reduce yields. However, the example of Japan has shown that low yields per se do not help much in fuelling aggregate demand or inflation if it does not fuel credit creation (see chart below).

Japanese monetary aggregates and economic activity (avg yoy change 1995-2000)

Source: IMES

In turn, US nominal growth should remain at historically low levels, warranting also low nominal bond yields for an extended period of time. My fundamental fair-value range for 10y UST remains at 2.50-3.00%. I was looking for UST yields to trade around the lower end of this range into autumn and for a low point to be reached during November before yields would be rising to the high end of the range during the winter months. A key reason for this assessment is economic seasonality. During autumn the economy usually re-accelerates following the summer lull. However, as the economy operates significantly below potential, this seasonality should not be as pronounced as is usually the case. In turn, I expected seasonally adjusted data for September and October to come in on the weak side. So far this is indeed playing out and economic data suggests that the US has significantly lost momentum going into autumn. But as the chart below shows with the help of the US employment report data, this seasonal effect is reversing during the winter months with generally weaker economic activity. As a result, I expect that seasonally adjusted economic data will increasingly paint the picture of an improving growth environment for the next few months (especially for December/January).

Economic activity usually weakens during winter

Source: BLS, Research Ahead

Given that the US Federal Reserve is now likely to embark on another round of QE just before this seasonality effect kicks in, the combination an even looser monetary policy with apparently improving economic environment will likely propel nominal bond yields sharply higher, i.e. well above the upper end of my fair-value range. Additionally, the prospects for QE2 have been mirrored by a marked shift in positioning in the UST market. Long duration position as measured by non-commercial longs in the US bond futures market or as measured by the JP Morgan survey of US institutional investors have become rather consensus and are at the highs for the year. Furthermore, whereas the technical picture up to the 10y part of the curve still looks supportive of ongoing yield drops, the developments in the 30y sector are sending a clear warning signal.
The combination of a likely improvement in the macro-economic picture over the next few months, significant long positions as well as a worsening technical picture for ultra-long bonds suggests that the bull-market in UST is likely coming to an end soon. I think that the low pint in 30y UST yields is already behind us whereas for shorter-dated Treasuries this does not yet seem to be the case. I expect yields to continue falling over the next 2-3 weeks amid weakfish economic data and given the upcoming Fed meeting with the likely start of QE2. However, it seems prudent to lighten up on longs already at this point in time and I reducie the long-held UST longs by half, looking to close the remaining longs at slightly lower yield levels over the next 2-3 weeks.

Forming upward trend in 30y UST yield is sending a warning signal

Source: Bloomberg, Research Ahead

Whereas in the US, the technical market outlook is darkening from the ultra-long end, in the Eurozone, it is the short end which has been guiding yields higher. The chart below shows that the 2y Schatz yield marked a low in June and has since been forming on a rising trend. Furthermore, the downward trend which started in June last year has been broken to the upside by now. 10y Bund yields, however, formed their low at the beginning of September and so far have only just broken through the downward trend in place since March this year. I have been looking for such a significant underperformance of German Bunds compared to their US counterparts. The reason for these diverging trends between the US and the Eurozone should be seen in the diverging economic behaviour as well as the clearly different stance of the ECB compared to the US Fed. For one, the Eurozone economy is doing relatively fine amid the strong growth of especially Germany. Furthermore, the ECB does not see further monetary easing as being warranted and seems rather happy about the waning interest in its liquidity provision measures. As a consequence the excess liquidity in the Eurosystem has been dropping significantly, putting upside pressures on ultra-short end yields and leading 3m rates back above the ECB’s 1% repo rate for the first time since mid-2009.

Bearish developments in the Eurozone emanate from the short-end

Source: Bloomberg, Resesarch Ahead

In light of this less accommodative monetary environment and given the ongoing favourable outlook for the North-Eastern Eurozone economies, especially Germany, the fundamental environment in the Eurozone will be increasingly favouring higher yields . As a result, German Bund yields have likely seen their yield lows across the curve and – similar to the US – should rise substantially during the next few months. Amid the tighter monetary environment as I expected initially, I raise my fair-value range for 10y Bunds from 2.25-2.75% previously to 2.50-3.00% and expect a test of the upper end during early 2011. In turn, I would close the remaining long positiions and establish first strategic short duration positions with a view of 3-6 months. The bearish development should be led by the 5y sector of the curve with the 2-5y spread stable to higher and the 5-30y spread likely to move to flatter levels.

Importance of SGIP for North-Eastern economies is low

2010-06-21T11:53:00.006+02:00

It is well-known that sovereign defaults in Spain, Greece, Ireland and Portugal would have devastating effects on the financial sectors of the rest of the Eurozone. However, I am convinced that while technically these countries might be insolvent they will not need to default given that the EU/IMF/ECB measures will keep them liquid. As I argued in the previous post (see Intra-Eurozone competitiveness: A solvable task) especially Spain, Portugal and Ireland have a high probability of being able to restore competitiveness and bringing their fiscal deficits back on a sustainable path over a period of 3-5 years whereas the outlook for Greece remains more challenging. The price to pay will be a longer-lasting deflationary recession and a significant increase in the sovereign debt-GDP ratio. However, especially for Spain and Ireland this should not be such a big problem as the starting debt-GDP ratio has been fairly low.
For the banking sector of the other Eurozone countries the fact that SGIP remain liquid and do not need to default while the ECB provides a floor to government bond prices means that the losses they incur are limited. Furthermore, the banks can slowly offload parts of their sovereign debt via the ECB's bond buying and as the EU/IMF refinance the maturing GGBs. Finally, the rising private sector defaults in SGIP will occur over a number of years and the sums involved appear manageable for the Eurozone financial sector.
What remains for the rest of the Eurozone are the economic effects from reduced demand by SGIP. I hear frequently that given Germany is such a big exporter and given SGIP are in a longer-lasting recession, Germany cant grow amid lack of export demand. However, it seems that no one looked at the data as this is just not true.
The table below shows the share of exports going into a particular region relative to total exports for various Eurozone countries. Due to data availability it covers only export of goods but not services (services account for about 20% of all exports). It highlights that the share of exports going to SGIP relative to overall exports is low for most Eurozone countries. In 2008 Germany exported only 6.6% of all exports to SGIP. This has come down further in 2009 to below 6% (EUR48bn vs. total exports of EUR808bn). According to Bundesbank data for services, the picture is the same. Germany exported 6.2% of all exports in services to SGIP in 2008 and 5.6% in 2009 (EUR 9.3bn vs. a total of EUR165.5bn). Except Portugal, due to the high export share going to Spain, only France and Italy have a share of more than 10%. As a side note, the UK – even though not being a Eurozone member - has a share of more than 12% of exports going into SGIP. Overall, demand weakness emanating from SGIP should not have a dramatic effect on the rest of the Eurozone.
Furthermore, exports of goods in the magnitude of more than 20% compared to GDP go outside the Eurozone for Germany, Austria, Finland, Belgium and the Netherlands. Together these countries account for 42% of Eurozone GDP vs. only 18% for SGIP. Furthermore, these exporters have relatively low fiscal deficits and in turn only a limited need for fiscal tightening. France and Italy face a less positive environment as they have a lower share of exports going outside of the Eurozone but will be impacted relatively more by the loss in demand emanating from SGIP and have higher fiscal deficits.

Euro has been weakening especially vs. competitors

Source: Bloomberg

Moreover, the Euro has weakened considerably on a trade-weighted basis which should give a significant boost to the exporters within the Eurozone and therefore for more than 40% of Eurozone GDP. Besides the weakening of the trade-weighted Euro which is based on trade relationships, the Euro has weakened even more vs. the currencies of key competitors. For example the direct trade relationships between the Eurozone and Japan are limited (accounting for 2% of all exports in goods and 3.5% of imports), but Japan is a key competitor in important industries such as cars and machinery. The fall by roughly 30% in the EURJPY cross rate over the past two years means that Eurozone exporters have become significantly more competitive in a short time-period. In turn, Eurozone exports should profit not only from Eurozone goods & services having become cheaper for its trade partners (or alternatively Eurozone corporates being able to increase their margins), but also that Eurozone goods have become much cheaper vs. close substitute products. Both factors should act to boost demand for Eurozone exports.
Consequently, we are likely to face a Eurozone economy where 18% (SGIP) will remain in a longer-lasting recession, 42% (the exporters) face strong external demand and Italy/France (accounting for 38% of GDP) will be able to muddle through. So far, the Eurozone’s current account has been close to zero amid very high deficits in Spain, Portugal, Greece and to a lesser extent France counterbalanced by substantial surpluses in Germany and the Netherlands. Going forward, the Eurozone current account promises to move into a significant surplus amid significantly lower deficits in Portugal, Spain and Greece and very high surpluses in Germany, the Netherlands and to a lesser extent, Finland, Austria and Belgium.

Intra-Eurozone competitiveness: A solvable task

2010-06-14T13:52:00.004+02:00

Much has been written about the unsolvable problems for Spain, Greece, Ireland and Portugal which ultimately can only be dealt with via default. Additionally, the enacted austerity measures have been condemned as hurting growth and therefore increasing the debt burden, raising indebtedness even further. However, one should not forget that these countries essentially face two challenges: Over-indebtedness (mostly of the sovereign in Greece and mostly of the private sectors in Spain and Ireland with a mixture in the case of Portugal) as well as low competitivity. Yes, austerity measures depress near-term nominal growth and in turn raise indebtdedness further, however, they help to restore competitiveness.While the road ahead for Greece appears particularly challenging, there is a high probability that Spain, Ireland and Portugal will manage to solve most of their problems over a 3-5 year time period.
It is frequently stated that SGIP need an internal devaluation in the magnitude of 20-30%. However, this estimate appears wrong on several counts. They are usually derived by comparing the development of nominal unit labour costs (ULC) in Germany with those in SGIP. For example, nominal unit labour costs increased by approx. 8% in Germany since 1999 whereas they increased by approx. 36% in Greece. This suggests that Greece has lost 28% in competitiveness vs. Germany and hence needs an internal devaluation of the same magnitude.
However, one should not forget that Germany joined the Eurozone at an uncompetitive exchange rate. It took Germany several years to restore competitiveness vs. the other monetary union members which was one factor for its weak economic performance early last decade. Assuming that Germany had re-established competitiveness by the end of 2003, reduces the gap in nominal ULC between Greece and Germany to 15% (and 14% for Spain and Ireland and 13% for Portugal). Finally, SGIP need not restore competitiveness vs. Germany but rather vs. the average of the Eurozone. Nominal unit labour costs in SGIP since 1999 increased by 34% whereas ULC in the rest of the Eurozone increased by approx. 21% (see chart below). The difference between these two developments is substantial but not insurmountable. SGIP either need a reduction in nominal unit labour costs of 10% or the rest of the Eurozone needs an increase in nominal ULC of 11% to restore competitiveness in SGIP. More likely though is that we will get a mixture of the two, falling ULC in SGIP and rising ULC in non-SGIP.

Nominal Unit Labour Costs in SGIP vs. the rest of the Eurozone

Source: Research Ahead, Eurostat

The development of Eurozone country inflation rates suggests that the re-adjustment process has already begun. As the chart below shows, inflation in Spain, Portugal and Ireland (grouped together according to their GDP-weight) dropped into negative territory. More importantly, inflation rates are significantly below those in the rest of the Eurozone. Only Greek inflation is headed in the wrong direction. Greece has clearly more work to do and its outlook remains uncertain even beyond the 3-year lifeline provided. However, Spain, Ireland and Portugal have the ability to restore most of the competitiveness lost within the next 3 years. At the same time the announced austerity measures go a long way in bringing fiscal deficits to much lower levels and in turn restore debt sustainability. The price these economies will pay is negative nominal growth as well as a higher sovereign debt to GDP ratio (which will prove sustainable once fiscal deficits have been reduced and given the relatively low starting point especially in Spain and Ireland).

Inflation developments: SIP have already started to restore competitiveness

Source: Bloomberg, Research Ahead

In turn, we will face a divided Eurozone, a longer-lasting recession with negative nominal growth in SGIP and an export-led growth rebound in the North-East which should take both their real growth and inflation rates into the 2-3% range. Current account deficits in Spain, Portugal and Greece should shrink whereas surpluses in the North-East will rise, leading the overall Eurozone into a significant surplus. In turn, the burden of the necessary adjustment to restore competitiveness and debt sustainability in SGIP will not only fall on the SGIP themselves (via deflation) but also on the north-eastern Eurozone economies (via a somewhat higher inflation in the medium term).

Wirtschaftswunder 2.0

2010-05-17T13:36:00.002+02:00

The vulnerability of the rest of the Eurozone to sovereign defaults in SGIP is extremely high amid substantial holdings of government debt in the financial sector. However, this danger has been averted for now. On the other side, the real economic fall-out from a long-lasting recession in SGIP should be limited amid low trade flows. For Germany, the combination of historically low nominal and especially real yields and a weaker exchange rate on the one side coupled with the structural reforms performed during the last decade and the high competitiveness being enjoyed by the corporate sector will help growth to become increasingly stronger. Exports are already surging ahead and there is a high probability that domestic demand growth will increase over the medium term from the subdued levels of the past decade. Watch out for growth exceeding 2.5% on average for the next several years.

If you would like to receive the full publication, then please send me a mail on daniel.pfaendler@researchahead.com

Research Cooperation Announcement

2010-04-12T16:02:00.004+02:00

I have started a cooperation with Finex, an order transmission broker offering services for listed derivatives on all major exchanges. I will provide topical and thematic strategic analysis which will include not only market opinion but also trade ideas executable in the listed markets.

In turn, I will have less time to devote to my blog and will be able to post only sporadically for the time being.

If you would like to receive the latest publication sent out today "Rates Strategy: Winds of Change II - Trade views for a bear market environment" or would like to be added to my distribution list, please contact me via daniel.pfaendler@researchahead.com.

Taking another break

2010-03-26T17:26:00.002+01:00

Following an accident-prone start to the year (once my wife had almost recovered, one of my sons was hit by a car), we are all going on vacation. The unscathed part of the family will try a week of skiing, hopefully without another visit to the hospital.
In turn, I wont be blogging for the next 10 days or so.

Rates Strategy Update: Winds of change

2010-03-23T12:54:00.009+01:00

On Mar 9 I proposed a neutral tactical outlook with a bullish tilt but at the same time confirmed that I expect Q2 to be a tough quarter for international bond markets (see Rates Strategy Update: Temporarily back to neutral). I now downgrade both, the tactical and strategic outlook (with a 3months horizon) to bearish.
There are several reasons for this change:
a) bond market seasonality: as written in detail last week (see A look at bond market seasonality dated March 15), especially April historically provides strong headwinds for bond markets.

b) the weather pattern: Winter was severe in the US and large parts of the Eurozone with heavy snowstorms. A strong winter goes hand in hand with weaker retails sales, weaker housing sales and construction. Furthermore, severe winter storms had a temporarily significant impact on traffic. In turn, economic momentum for the December-February period should have been weaker than the underlying trend implies. However, the weather is not responsible for the underlying trend and as the weather normalises, economic momentum should improve again and temporarily be above the underlying trend (as parts of the loss in retails sales/housing market turnover should not be permanent but just have been delayed, i.e. there should be some pent-up demand which will be released once weather conditions have normalised again).
I previously showed a very profitable trading model based on the prevailing temperature for a given month vs. a multi-year average. The temperature is measured in so-called Heating Degree Days (and Cooling Degree Days for the summer months), a population weighted measure for the average temperature prevailing in the US. The model enters a receiving position in the USD 10y swap rate in a month following a colder-than-usual winter month (and warmer than usual summer month) and a paying position otherwise. For more details see for example Here Comes the Weatherman II).

However, there is also a good correlation between the HDD deviation from norm (with a positive number meaning that it is colder than usual and vice versa) and the Chicago Fed National Activity Indicator (the index is a weighted average of 85 indicators of economic activity and seen as a co-incident indicator) as the table below shows.

	HDD deviation from norm	CFNAI
October	49	-0.90
November	-97	+0.14
December	50	-0.50
January	14	-0.04
February	78	-0.64

November - which had unusually cold weather - saw a sharp rise in the CFNAI. However, the cold December and the cold February saw much lower levels of the CFNAI. January - with a close to average temperature - saw a temporary spike in the CFNAI.

However, if we look at weekly HDD data, the temperature prevailing in the US has turned warmer again earlier this month:

Week Ending	HDD deviation from norm
02. Jan 10	19
09. Jan 10	49
16. Jan 10	2
23. Jan 10	-44
30. Jan 10	-7
06. Feb 10	11
13. Feb 10	34
20. Feb 10	16
27. Feb 10	20
06. Mrz 10	15
13. Mrz 10	-24
20. Mrz 10	-28

Overall, March has been warmer than usual so far. If that is not reversed by the end of the month, then the weather would become clearly bond market negative.

c) the end of the Fed's mortage bond buying programme: The Fed will end its bond buying programme at the end of this month. The programme totalled USD 1.25trn and helped bringing mortgage rates lower. As this happened, other potential buyers of such product were looking for yield elsewhere and helped bring credit yields lower. Furthermore, the average duration of mortgage related securities (given that they have a prepayment option embedded) was reduced and likely fuelled a wave of convexity hedging (via receiving in swaps and to a lesser extent also buying of UST). This should have been a factor explaining the tightening in USD 10y swap spreads as the chart below tries to show (it shows the 10y USD swapspread and the Mortgage Bankers 15y fixed rate mortgage yield).

10y US Swapspread and 15y fixed rate mortgage show high correlation

Source: Bloomberg

However, as the massive buying ends while on the other side the supply of bonds will remain, it is likely that MBS yields will have to rise to find new buyers. With that the duration increases again and convexity hedging might move the other way, i.e. into a swap paying position. This should also take swap rates and swap spreads higher again and also exert a rising pressure on US Treasury yields.
d) Technicals: On daily charts, the technical situation in 10y Bunds starts to look overbought. Furthermore, while the previous rallies were accompanied by rising volumes and the setbacks by falling volumes, the latest rally saw volumes declining further in both the 10y Bund future (see chart below) as well as the 10y TNote future. This suggests a changing trading behaviour and puts the latest rally on a weaker footing.

10y Bund future and volume: latest rally is not accompanied by rising volume anymore

Source: Bloomberg

Overall, this suggests that the current rally in bond prices is likely to end soon and should give way to a markedly negative trading environment with a likely significant rise in yields on an end-Q2 view. In light of this, I downgrade my strategic call from neutral to bearish (looking to re-enter longs around the end of Q2) and also change my tactical outlook from neutral with a bullish tilt to outright bearish. UST yields seem more at risk than their Eurozone core counterparts and I expect UST-Bund spreads to continue on their widening path.

A look at bond market seasonality

2010-03-15T10:01:00.004+01:00

Currently I have a neutral tactical call with a bullish tilt (see Temporarily back to neutral dated March 9) and a neutral strategic duration call. However, my view is that Q2 will be difficult for international bond markets amid a temporary re-acceleration in growth following a severe winter. Furthermore, bond market seasonality has its strongest negative effects in April, a topic I will explore on below.

When looking at bond market seasonality, several issues arise:
- seasonality studies need a long time history in order to make the results somewhat statistically meaningful (even if one uses 20 years of data, that still gives only 20 data points per month)
- benchmark bond yield histories face the drawback that the underlying benchmarks change over time which distorts the yield history
- bond yields can trend for decades but in a seasonality study one does not want such trends to influence the outcome (for example bond yields have been in a bear-trend over the past 25 years).

One time series which offers itself for a seasonality study are the constant maturity treasury yields (CMT) as provided by the St.Louis Federal Reserve. They go back to 1962. Firstly, this provides a longer than usual time series (49 years of data which, however, is still not that much). Secondly, given that they are CMT yields, they do not suffer from benchmark changes. Thirdly, in 1962 10y CMT were at approx. 4%, i.e. not far away from the current level of around 3.70%.

The chart below shows the average change in basispoints during the various months. In addition, it shows the net number of months during which yields rose in between 1962-2009. As can be seen, during this time period yields rose on average from January to May and fell thereafter until year end. Furthermore, this was not achieved by some outlier months with huge yield changes but rather by a significant larger number of months seeing yield rises than yield falls (from Jan-May) and vice versa especially in June and from September-December.

Strong seasonality in the US 10y CMT rate from 1962-2009

Source: St. Louis Federal Reserve, Research Ahead

To better highlight this seasonality, the chart below shows the p&l from being short bonds from Jan-May and from being long bonds from June-December. As can be expected from the average yield changes, both, the short and the long trade produce significant profits over this time period. What is more, while the long trade only really starts to perform from the early 1980s onwards (i.e. once the structural bond bull-market sets in), the short trade performed during both, the bear-market of the 1970s and more importantly the bull-market of the 80s/90s and 00s.

A bond-bearish move until May seems to be a feature of a bull as well as a bear market

Source: Research Ahead

In order to test for a different behaviour during the Great bull and bear markets, I divided the history in two sub-segments from 1962-1981 (when the yield high was reached) and from 1982 to 2009. The table below shows the average yield changes during both sub-periods. It is interesting to note, that during the bear market, yields on average rose almost throughout the year (except during November) with the largest yield rises in January, February and July. During the bull market, however, the dispersion of average yield changes was much wider (26bp vs. 13bp) and yields fell on average only during 6 months (June and August-December).

Average monthly change during the Great bear market and the Great bull market

Month	Jan62-Dec81	Jan82-Dec09
January	8	2
February	9	1
March	1	8
April	3	13
May	2	0
June	2	-5
July	9	0
August	5	-9
September	3	-11
October	6	-13
November	-4	-11
December	2	-4

Source: Research Ahead

Furthermore, while during the bear market, the average rise in yields in January and February was larger than during the bear market, the average rise in yields for March and April was much higher in the bull market than previously.
Now, if we do not know whether we are in a structural bull or bear market and the above pattern still holds, this would suggest that shorts are most preferable in March and especially April while longs seem to be advisable especially in November. But it also suggests that even if one assumes that the bond bull market has not ended, being invested early in the year does not pay on average and one should be more active in H2 of any given year.
While I do not advise to invest purely on historical seasonal patterns, it supports my stance that Q2 might be a difficult quarter for international bond markets.

Rates Strategy Update: Temporarily back to neutral

2010-03-09T10:07:00.004+01:00

I adopted a neutral strategic outlook and a negative tactical outlook on Feb 18(see: Rising risks of a rise in yields). While initially bond yields rose (on the back of the discount rate hike in the US), they have fallen back subsequently and are currently some 10bp lower. I continue to expect especially April and May to provide a challenging environment for government bonds with a likely significant rise in yields into mid-year. Reasons are the adverse winter weather which led to a more pronounced seasonal downswing in economic activity, but should be followed by a more pronounced upswing later on. Furthermore, April and May are usually the cruellest months for bond investors (I will write more on both at a later stage). Finally, while government bond supply will continue unabated, the US Fed's buying of MBS is drawing to an end at the end of this month.
Therefore, I continue to see a pronounced risk of a significant rise in yields over the next months. However, over the next 2-3 weeks, the balance of risk is favouring a different view and I therefore adopt a neutral tactical outlook with a bullish tilt, looking to re-enter shorts at a later stage.
A) Positioning: Short positions have been reduced somewhat since the extremes reached in mid-January. However, they still do not seem to be at a level which historically has been associated with a significant move higher in yields. The chart below shows the aggregated positioning by non-commercial accounts in the US 2y, 5y, 10y & 30y futures (weighted by the respective pvbp of the futures contract). The last data point relating to March 2nd is marked in red.

Aggregated positioning by non-commercial accounts in US bond futures

Source: CFTC, Research Ahead

b) The weather: I have written several times on this subject (see for example: Here Comes the Weatherman II dated Feb 25). Unfortunately, the weather has remained colder than is usually the case going into March. The table below shows the population weighted heating degree days (HDD) per week for the US as well as the deviation from the historic norm for that week. A positive deviation means that there were more heating degree days and in turn the average weather was colder than is usually the case.

Week ending	Heating Degree Days	Deviation from norm
02. Jan 10	222	19
09. Jan 10	256	49
16. Jan 10	211	2
23. Jan 10	164	-44
30. Jan 10	198	-7
06. Feb 10	210	11
13. Feb 10	225	34
20. Feb 10	196	16
27. Feb 10	188	20
06. Mrz 10	172	15

Source: NOAA

The year started colder than usual with a milder period in the second half of January. Thereafter, the weather turned colder again and has remained so for the past five weeks. Again as a reminder a stronger-than-usual winter should be especially bad for retails sales, construction activity & home sales. Given that it seems to last well into March and March is usually a month with a high seasonal acceleration in economic activity, the seasonally adjusted data for early March promise to turn out relatively weak. In turn, bond markets are likely to remain supported for the next 2-3 weeks.
c) Technicals: So far the technical picture does not provide a sell signal. While bond markets were overbought in the midst of February when I suggested a tactical short, this situation has corrected in the meantime and I would consider technicals as largely being neutral with a bullish tilt as the bullish trends in the 10y UST and Bund future contracts remain in place. The chart below tries to highlight this situation for the 10y US future. The bearish trend-line which was about to be formed by the highs reached in late November and early February was broken to the upside whereas the two upward slopinng trendlines (one since July last year and one in place since the start of this year) are still in place.

10y US Treasury future still guided by upward sloping trend

Source: Bloomberg

Overall, I still look for a potentially significant rise in yields during April/May and stick to a neutral strategic view. However, the next 2-3 weeks might rather see a temporary move lower in both, US and Eurozone yields. In turn, I change my tactical outlook from negative to neutral with a bullish tilt, looking to re-enter shorts at a later stage.

A European Monetary Fund?

2010-03-08T11:21:00.003+01:00

The discussion about installing a European Monetary Fund (EMF) seems to gather speed. Not only has Thomas Mayer together with Daniel Gross proposed an EMF erlier this year (see here for their original paper), but also the German Finance Minister Schaeuble has argued in the same direction over the weekend and now as Bloomberg reports, the EU Commission seems to be ready to propose an EMF-type instrument. As reported, the proposal should be ready by June. This highlights that the political will to continue with the European integration project remains strong.

Such an EMF - depending on how it is done - could go a long way in addressing some of the shortcomings of the Eurozone (it is frequently stated that no currency union has survived without a fiscal union).
The stability and growth pact tried to partially correct for some of the shortcomings in establishing limits on debt and deficits. The hope was that the SGP would force a sustainable path for the sovereign sector and in turn there would never arise a situation where a sovereign would risk bankruptcy and/or be in need of member-states' bailout money. However, even before the SGP was dramatically weakened it failed to enforce fiscal sustainability.
An EMF - besides acting as a lender of last resort - could provide stronger incentives to promote fiscal sustainability in the first place. For one, Gross and Mayer propose that the EMF would be financed by a fee based on the fiscal deficit exceeding 3% and on the sovereign debt exceeding 60% of GDP. Finally, the EMF would also manage an orderly default of a member state.
Such an EMF for the Eurozone would clearly strengthen its institutional set-up and render it more resilient against shocks via a) the promotion of fiscal sustainability during good times and b) the support provided during a crises.
I personally am clearly in favour of such an EMF, even though it might take a long time to set it up and even though the institution which will likely be established will be far from perfect. However, it still cannot account for the fact that the Eurozone is not an optimal currency area and especially labour mobility between countries remains relatively low. Asymmetric shocks in such a set-up will continue to hit member states again and again.

Should the Inflation Target Be Raised?

2010-03-02T11:56:00.004+01:00

The discussion about the right structural inflation level to be targeted by central banks has resurfaced. Most notably Olivier Blanchard, head of the research department at the IMF, has proposed that inflation targets should be raised from around 2% at present to 4% in order to reduce the economic costs associated with hitting the zero nominal bound. He makes his case in a paper entitled Rethinking Macroeconomic Policy and in a shorter-version interview (see here). His main argument is that with a somewhat higher inflation rate, central banks could have slashed rates more during the financial crisis before hitting the zero lower bound.
Blanchard is not alone in calling for a higher inflation target and for example Prof. Krugman supports higher inflation targets (see The case for Higher Inflation Inflation) where he adds that: "... even in the long run, it’s really, really hard to cut nominal wages. Yet when you have very low inflation, getting relative wages right would require that a significant number of workers take wage cuts. So having a somewhat higher inflation rate would lead to lower unemployment, not just temporarily, but on a sustained basis."
In turn, the problems associated with the zero lower bound as well as the distortions emanating from certain prices being difficult to reduce in nominal terms (I would also add that this does not only apply to wages but also to other prices as for example it is difficult to lower rents in nominal terms unless the renters move), create costs if inflation falls too low or becomes negative.

On the other side, there are various costs emanating from higher inflation:
a) Relative-price distortions: Not all prices inflate at the same rate, and so inflation generates some relative-price distortions which lead to resource misallocation. The higher the inflation rate, the greater these distortions.
b) Stability of inflation expectations: It is much more difficult to have stable inflation expectations at higher levels than at lower ones. In turn, the higher the inflation rate, the larger the danger, that inflation continues to move up ever further.
c) Unexpected inflation: Empirically inflation is also much more volatile at higher rates than at lower rates. In turn, unexpected inflation tends to become a significant problem, the higher the inflation target is. Unexpected inflation also leads to significant ressource misallocation.

A high level of relative price distortions as well as unexpected inflation will directly lead to ressource misallocation. Furthermore, both act to raise long-run risk premia. From a bond market perspective this means a steeper yield curve and in turn higher costs to raise long-maturity funds. From an entrepreneurial perspective it means that long-term business investment proejcts bear a higher risk (it is more difficult to forecast the business environment/cash flows) and a higher cost (again amid higher risk premia incorporated into financial markets). In turn, not only will there be a higher level of ressource misallocation but also the hurlde to carry through long-term investments is higher than in an environment of low unexpected inflation and limited relative price distortions. Both will act to weigh significantly on trend growth.

In turn, we should not be surprised to find a negative relationship between inflation and growth at higher levels. But what level exactly? The IMF itself in a research paper from 2001 (see here) found that: " The threshold level of inflation above which inflation significantly slows growth is estimated at 1–3 percent forindustrial countries and 11–12 percent for developing countries. The negative and significant relationship between inflation and growth, for inflation rates above the threshold level, is quite robust."

As a result, I fail to be convinced that a higher inflation level would provide a more favorable monetary environment for the major economies and think that it would depress trend growth rates resulting in ever increasing costs for society.