Cracks in the Eurozone Edifice?
Thursday, January 17, 2008 at 08:16AM It should be clear for everybody at this point that economic momentum in the Eurozone countries is now set to take a turn for the worse. Even for those who believed (note the past tense) in the notion of de-coupling as it was traditionally conceived I think that the trajectory of incoming data suggest quite clearly what comes next with respect to the overall picture. Ever since the ECB and the Fed parted ways back in the Summer/Autumn 2006 and the longer the ECB decided to stay pat it was pretty clear how all this would all end except for those who had blind faith in the de-coupling idea. In this way it is difficult to say whether the ECB actually bought the de-coupling argument or whether they always and only were looking at inflation. No-one in their right mind would argue for complacency against inflation but as I have argued before I think there are some major disconnects in the ECB's analysis. I mean, what is their official target for the M3 again, 3-4%? And it is currently running at 11-12% so clearly this is a little beyond something which can be tweaked with the refi rate (even if they decided to hike) which perhaps suggest that those instrument rules should be applied with caution. Also, if we are really looking at stagflation it could easily turn into deflation and then we are moving into a much more serious game in the intermediate to long term with Italy, Portugal contemplating to leave the zone just to name but a few of the ghosts which could emerge. Then there is the Euro of course which is the epitomy of the whole de-coupling argument. Be careful what you wish for would is what I say here and if it is de-coupling you want so be it; but how long can Europe muddle along with a EUR/USD at 1.50? Not long of course and it may not even come to that as I will indicate below.
If you want a complete overview of the recent slew of data from the Eurozone and its individual countries I will refer to the Euro Watch blog maintained by Edward and me which follows the day-to-day progress of the aggregate Eurozone economy. The Euro Watch blog will also lead you to country specific blogs for all the major Eurozone economies.
The first thing I want to note this time around in the context of the stream of incoming data in the Eurozone is the most recent reading from Germany with respect to the ZEW investor confidence index taking another plunge in January that thus indicates and essentially confirms where things are going. However, what is perhaps more significant in my book was the news from Italy which just goes to hammer down the traditional series of dynamics we are seeing as the Eurozone economy enters the downturn. Basically, the growth forecasts for Italy (and elsewhere) are being scythed at the moment and slowly but steadily coming in line with those made by my colleague Edward a month ago as we exited 2007. Yesterday we then had the Bank of Italy who moved its forecast for 2008 down from 1.7% to a measly 1.0%. And take note, this is well before we have any real data at all from this year as well as of course those Q4 07 figures. As such, I feel confident in my view that Italy will see a recession in 2007. Now, it remains to be seen whether the other Eurozone countries will move down into recession mode too. This is a bit more unlikely I think and much will as always depend on Germany as well as another line of key risk events.
This then takes us to the ECB and the probability that we might see a cut sooner than later. To that end we need to look at inflation where the recent figures suggest 'stable' condition with a 3.1% reading for December 2007 which is still well above the 2% target. As I noted in the context of the last ECB meeting there was no decisive change in the ECB stance and more importantly no indication as to what might actually move the ECB towards a more a dovish position. However, we learned yesterday that the markets are certainly watching messages emitting from the ECB very closely. In this way, the EUR/USD took a surprising dive from its previous highs on the back of ECB council member Yves Mersch's remarks that growth risks were clearly tilted to the downside ...
Mersch's comments, the fifth from an official this week to suggest that the ECB is toning down its inflation-fighting language, led to the biggest drop in the euro in a month. While President Jean-Claude Trichet on Jan. 10 threatened to raise rates, Germany's Axel Weber said yesterday officials shouldn't ``over-dramatize'' the pick up in inflation.
I think I even saw 1.459xx on my screen at some point. Whether it is time to follow my advice voiced earlier in the month and sell the EUR/USD with everything you got is a bit more dubious. There would be considerable risk to such a position at this point since we know that before the ECB will have the opportunity act (or not) the Fed will almost certainly cut interest rates once more. In this way, and if we try to identify the risk factors going forward from here I would point to the following which all ties together two intimately related questions; what trajectory will inflation and economic momentum indicators have going forward and how will this affect (or not) the ECB's position?
- As for general economic indicators I think their trajectory in the immediate future is a foregone conclusion and the real question is really the extent to which it will have a bearing on the ECB. Inflation indicators will be gauged very closely in this connection. Any indication that inflation is abating just a little bit could send the EUR/USD on a roller coaster ride I think but if inflation indicators take another turn upwards my guess is that this will be seen as indication that the ECB will postpone a future interest rate cut. I also think that we need to contemplate the fact that the ECB might be ready to suffer a recession in Europe if it means that rates can be kept on hold. However, given the likely path of the economy in 2007 this would be a pretty narrow interpretation of the ECB's mandate (a put option basically) and I really hope that pride will give way to due diligence.
- Regarding concrete dynamics I think that a very sour reading on Q4 GDP for the Eurozone could potentially lead to a cut as soon as in the March session especially if the Germany and/or Spain are shown to have stalled already as they exited 2007. This would of course prove the final blow to the EUR/USD and could see the pair moving to 1.40 and further downwards but I want to emphasise that this is not in any ways an actual call. The EUR/USD might just as well shoot up towards 1.50 again before we see the move down, so place your stops with care and prudence!
- As is now readily clear it is not merely the Eurozone edifice which is struggling, so is the global ditto with equity markets in most corners of the world showing signs of distress. Especially in this light I am watching Eastern Europe with some weariness. Yesterday as well as today we saw some hefty tumbling of equities in Eastern Europe and what is not at all insignificant was the transmission mechanism to Austria where we subsequently also saw that markets were jittery. Basically, this is part of a bigger story (I think) about how Austrian banks among others have been supplying loans denominate in foreign currencies to households in Eastern Europe; (see my recent note on Lithuania which contains some general information on this). Whether the imbalances in Eastern Europe are now set to unwind remains to be seen but the risk is mounting and this at a time where risks are plenty elsewhere.
Conclusively, we can simply say that these past days have presented events and indications which serve to turn the screw just a little bit more in the Eurozone. Whether it will change the bias at the ECB is yet to be seen. Perhaps Yves Merch's faut pas is a sign of things to come and I am sure that the phones in Frankfurt are red-hot at the moment since if there is one thing that matters for Trichet it is to keep a straight face towards the external environment. This might of course be impossible as we move forward and if the economic data continues to come in as we are seeing at the moment the stance will likely change sooner rather than later.
Reader Comments (3)
If there's one field an investor needs to diversify today, it are currencies. Although not money, I include PM's in these currencies, which are attractive in an environment with negative real interest rates and declining asset prices (real estate, stock market).
For other currencies I only differ from your pov that the counterpart of my bets will not be the USD. I'll briefly explain why.
The slowing economy, the financial link with Austria, the razor thin margins on loans in Spain (see Hugh), ... will ultimatily push the ECB to lower rates. My guess is that there will be little resistance from other member states as long as challenges are somewhat similar. By March the entire Eurozone could welcome a cut (I take March because that's the moment earnings really start to pour out in Europe).
If the ECB doesn't adhere strictly to the rules (target inflation) and some members don't really insist on it to do so, we'll stick together for a while still.
It would neither surprise me that the Fed and the ECB will mutually decide to cut rates (in March). For now Bernanke cannot cut (to prevent the dollar from falling) and awaits the pain the already low dollar will inflict on the Euro-economy, as you pointed out too.
The ECB cannot cut in advance, if earnings are going to be disappointing in some sectors (Spanish banks?), then the ECB needs to react the moment the problem presents itself to the market. A cut now would deprive the ECB from its psychological munition when it's really needed.
But Mankiw writes on his blog (Fiscal stimulus and Fed policy):
"If the U.S. government is using fiscal policy more, it should use monetary policy less."
geert
Thanks for stopping by. I have also been following your discussion with Edward over at Bonobo Land in the context of the post on France. Very interesting. Also very good point about earnings and the dynamics with which this data could lead to a cut. I think that is very plausible.
As for the ECB and the Fed I have difficulties seeing coordinated action at this point. Basically, Trichet is boxed in and no matter what happens he is likely to end up with egg in his face if he lowers as soon as in March. But then as you say, if the earnings figures turn out to be abysmal and if the general economic conditions continue to turn for the worse then he may have to cut of course. But whether it will be coordinated is another question I think. In essence, Trichet and Bernanke don't seem to see eye to eye on this.
As for Bernanke he is taking a lot of flak at the moment. Especially, he is seen in many circles as falling victim to the Greenspan put mantle and providing liquidity(bailouts) too fast. I don't take this view however, but it is definitely a very delicate situation.
As for the proposed fiscal package. Yes, I agree with Mankiw here. I mean, the package looks very comprehensive an expense which means that Bernanke could and should hold off with the lowering of the rates, at least he should lower less than had been initially anticipated.
Claus
Thanks for your comment and in general for your analysis.
The probability that Trichet won't cut that early is higher than my scenario. I must admit that my scenario is based on reversed reasoning, namely departing from technical analysis of the stock market.
On top we don't know whether Trichet will be as much of a slave of circumstances as Bernanke is. I was somewhat surprised that Bernanke gave the introduction to the fiscal stimulus package as this is not his field of operations.
best
geert