Posts tagged ‘euro’
Tomorrow’s election in the Netherlands may not be very exciting after all. Until recently it looked as though the nationalist PVV would emerge the clear winner, to the extent that keeping its leader from the Prime Ministership would be very difficult. (PVV wishes the Netherlands to leave the European Union among its other policies.) But then the party’s leader, Geert Wilders, was convicted for inciting discrimination before Christmas, and as the campaign got underway the incumbent PM, Mark Rutte, deployed much hard rhetoric and advertising on PVV’s key issue, immigration. The current polling is finely balanced. Mr Rutte has repeatedly ruled out coalition with Mr Wilders. Dutch politics may remain an earthquake-free zone; we will soon know either way.
Eurozone asset markets are priced rather sanguinely in any case. Back in 2011 it was the bond market, and specifically the Italian bond market, which threatened to ignite a wholesale global banking collapse with an internationally unaffordable sovereign default. Back then, the credit default swaps which can be bought to hedge against Italian credit risk cost almost 6% over LIBOR, as against 6bp in mid-2007. Today the rate is 192bp: higher than the pre-credit crunch levels, but then Italy has been downgraded from AA to borderline junk since then. Even the end of the country’s government last December at the hands of a referendum seen as a valve for anti-Establishment sentiment did relatively little to move the price.
Elsewhere in the euro area the story is similar. The exception, which is worth dealing with separately, is Greece. Here the debt burden, which has of course already been restructured once, has reached over 180% of GDP. The IMF – one of the “troika” of creditors dictating Greek fiscal policy – has said that it has again become unsustainable. Fraught negotiations with the Greek government have continued. But none of this is news. Furthermore the Bank of Greece’s November estimate for the country’s budget was of a “primary surplus” (budget balance before debt interest) of +4% of GDP, indicating both a sustainable underlying spending pattern and compliance with creditor demands. There are those who expect the contradiction between monetary union and fiscal autonomy to upend the single currency at some point, but then at the zone-wide level debt to GDP peaked back in 2014 and again, this is hardly news.
Another recent source of concern over Europe was the banking system – or, to be more accurate, the solvency (or otherwise) of various European banks. Deutsche Bank caused consternation for a time, but then the German government has been cutting its debt burden since 2010 and if anyone can afford a major bailout, it is surely them. In any case, no bailout was necessary; DB shares have risen by more than 70% from their lows. Where restructuring has been needed, at Banca Monte dei Paschi di Siena, it has not been anything like sufficiently material to threaten the whole Continent. And where banks are daily dependent on emergency central bank facilities (Athens), this is, once again, not news. Their shares have been available for a handful of cents for years.
There is only one moving part that has shown real signs of weakness: the euro itself. This has fallen by 23% over the last three years. Its low against the dollar of $1.0388 back in December was the weakest level it had reached since the opening sessions of 2003. However, even this is not a credible sign of structural malaise. The currency has been much lower still in the past, hitting an all-time record of $0.8272 in late 2000. And while the ECB has been loosening policy in a range of ways, the Fed has embarked on a tightening cycle. Like the Italian credit spread the euro’s weakness can be interpreted as nothing more than a rational response to changed circumstances.
In other words, there appears to be nothing to see here. Political risk remains, yet seems not to be priced in.
This blog argued at the time that the support of the stronger eurozone economies for the weaker ones in 2010 answered a key existential question for the single currency. In theory, (a) there is no debt mutualisation in Euroland and (b) its members enjoy complete fiscal autonomy. In practice, when the going got tough, there was a very EU-esque “pooling of sovereignty” over debt via the European Financial Stability Facility / European Stability Mechanism. And bailout nations have had to comply with the rules of their emergency lending regimes.
There is another factor to consider, however, and that is Brexit. Attention in the UK tends quite understandably to focus on the consequences for ourselves, but there will also be consequences for the rest of the EU.
A harsh deal, or no deal, with Britain, and some businesses and industries will suffer. It was interesting that a senior executive at global food giant Mars Incorporated spoke about this a few days ago. Agriculture has managed to remain immune to the GATT / WTO decades of compromise on tariff reduction and quota control. Look at the WTO tariff tables and food, drink and tobacco are about the last redoubts of punitive import duties. From the BBC last Friday:
Fiona Dawson . . . said the absence of a deal with EU member states would see tariffs of up to 30% for the industry.
Speaking at the American Chamber of Commerce to the EU, she warned this would “threaten [the] supply chain and the jobs that come with it.”
“The absence of hard borders (in Europe) with all their attendant tariff, customs and non-tariff barriers allows for this integrated supply chain, which helps to keep costs down,” she said. “The return of those barriers would create higher costs which would threaten that supply chain and the jobs that come with it.” Ms Dawson said those costs could not be absorbed by confectionery companies, meaning consumers would have to pay more for their products . . .
Companies in the automotive and the financial sector have been the focus since the vote, according to Ms Dawson. But with food and drink the largest manufacturing sector in the UK, accounting for 16% of turnover, she said she wanted a new focus, and called for EU leaders to look at the bigger picture when negotiating. “There can be no economic advantage either side restricting trade with a large market situated on its doorstep,” she said.
“In simple terms, if the UK and the EU fail to agree on a new preferential deal, it will be to the detriment of all. Other member states should remember this is not about ‘punishing’ Britain for her decision to withdraw, but rather about finding the best solution for European and UK workers and consumers.“
The emphasis at the end there is my own. And it is not just manufacturers who could, in theory, be walloped in this sector. Pity the poor farmers, logistics firms, supermarkets, restaurauteurs who would be crippled by the reimposition of border controls. (The EU’s “Border Inspection Post” system is, to put it mildly, neither rapid nor straightforward. Our own government has helpfully printed the details here.)
A no-deal Brexit, then, would entail potentially disastrous consequences for certain sectors.
This is not priced in. Does this mean that Britain will leave with many of the customs union’s features still in place? That we will, as Ms Dawson clearly desires, not be “punished”?
That is a possibility but it could spell the end of the EU, which appears not to be priced in either . . .
Just imagine. An economically benign Brexit would mean Britain securing a free trade deal that goes way beyond current WTO rules in the key areas of agriculture and fish, while maintaining border control-free access in these and related markets. At the same time we would be regaining complete control of our immigration, lawmaking and judicial processes – and saving part, if not all, of our contributions to the Brussels budget.
A core of true believers – Luxembourg, for instance – might want to stay in the bloc and accelerate the move towards political federation. But surely, plenty of other “member states” would want to follow such an example.
This year’s electoral cycles across the Channel may not threaten the euro, then. But Brexit seemingly has to threaten either some sector-specific but nonetheless material economic damage, or the continued existence, to some extent, of the EU. If a eurozone country wanted to leave the EU, it could in theory continue to use the single currency. But might financial market pricing, by that point, not have begun to look rather different . . ?
So much of the focus has been on Article 50 and the possibility that Brexit might be somehow derailed that thinking has yet to turn to this apparently logical conclusion. The question for investors is: what are the euro assets which are so compellingly attractive that one should wait until it does so?
Think “political risk in Europe” this year and you would most likely have thought about the Brexit vote. It is of course true that Britain faces an uncertain future, and that Brexit will have consequences for the EU too. But it is far from the only game in town.
On Sunday week the electors of Hungary will cast their votes in a referendum on the issue of migrants. Specifically, they are being asked if they accept the EU’s allocation of a migrant quota to Hungary without the consent of their national parliament. The most recent opinion polls suggest that anywhere from three to four percent of citizens are inclined to vote, “yes”. Barring a miracle, Hungary is about to throw down the gauntlet to Brussels in a few days. This has already appalled one or two other EU members: Luxembourg’s most senior diplomat has called for Hungary to be expelled from the Union altogether. In response the Hungarian government is calling for treaty change (specifically reform of the constitutional Treaty of Lisbon).
The question for investors, of course, is: will markets care about this? Even if Hungary were to leave the EU it isn’t in the euro and is a smallish country, so the answer, in isolation, is almost certainly “no”.
It is equally obvious, however, that the Hungarian vote is not an isolated incident. Portugal was talking about a Greek-style referendum on bailout terms over the summer, though this has yet to amount to an actual plan (and didn’t do Greece herself any good in the event either). And next week the Italian cabinet is to fix a date for a referendum on constitutional reform. The detail here is extremely boring but Prime Minister Renzi staked his political future on the outcome. He has tried backsliding on his promise this week but by turning the referendum into an effective vote of confidence in his government it is being seen as a conduit for Italian euroscepticism. This has gained sufficient strength for the Five Star Movement – an anti-establishment party founded by a comedian which sits in the same group as UKIP in the EU parliament – to be leading the polls. “M5S” does not actually want Italy to leave the EU – but it does want a referendum on the euro. In the meantime opinion polling suggests that the constitutional referendum is balanced on a knife edge.
Will rising Italian euroscepticism, or at least anti-euro feeling, present a challenge to the markets’ confidence? Not in isolation perhaps . . .
The Italian situation might well be complicated further should neighbouring Austria elect Norbert Hofer of the Freedom Party to be her president this December. Mr Hofer, who is currently in a dead heat with his Green Party opponent, once called for the border with Italy to be changed and the province of South Tyrol to be incorporated into his own country. Be that as it may he certainly wants to close the Italian border to migrants. And there is more: the last time the Freedom Party came into power (as part of a coalition in 2000) the EU imposed sanctions. Would they do so again?
Looking to the new year, the Netherlands will hold elections in March. There, another party with “freedom” in its name is topping the polls and its leader, Geert Wilders, once banned from entering the UK for his views on Islam, could end up as premier. He and his party want out of the EU.
Soon after the Dutch it is the turn of the French to vote for their president. Marine Le Pen, leader of the National Front, is almost certain to wind up in the second round vote, probably against a centre-right opponent. Like her father in 2002 she will almost certainly go on to lose, but her share of the vote will be interesting. The National Front is, as its name suggests, a nationalist party and has always opposed the existence of the EU.
Then, at around this time next year, we will have the Germans. The migrant crisis has propelled support for a new eurosceptic party, the Alternative for Germany (AfD) to 16% in the polls. It has been winning seats in regional elections. It looks set to establish itself firmly as Germany’s third party come next autumn. Some of its members have an enthusiasm for Nazi memorabilia and have defended some of the actions of Hitler’s government. The party has not yet advocated EU withdrawal, but it was founded to bring back the Deutschmark and stop Germans having to bail out other member states. It is also implacably opposed to immigration, effectively opposed to the idea of the Schengen area and overtly anti-Islamic.
Again, it is possible that the EU and the euro will muddle through all this. France and Germany are not going to elect eurosceptic governments, yet. Wilders’ lead in Holland is not unassailable – and the collaboration of his main opponents could, in theory, keep his party out of power anyway. It is impossible to predict these things but it does seem unlikely that the single currency will be seen to be facing as much of a threat over the next twelve months as it was seen to be facing at the nadir of the sovereign debt crisis in 2011.
The risk, however, is there.
Apart from the voting calendar there are simmering tensions to consider within the EU bloc. Perhaps most serious among these is the stress caused by the migrant crisis. The “Visegrad Group” comprising Czechia, Hungary, Poland and Slovakia submitted a list of
demands proposals at the Bratislava summit last week which included flat opposition to mandatory migrant quotas. The EU is at loggerheads with Hungary and Poland over constitutional issues; meanwhile the Polish and Hungarian leaders are extremely close allies who hold frequent bilateral meetings. This is a barrier to sanctions which some in the EU would like to impose on Poland. (It is seen as a lesser problem that the current Polish government swept to power last year with the first absolute parliamentary majority since the restoration of democracy in 1989.)
Of course there are external issues to consider too, most notably relations with Russia and Turkey. Even more widely, the Brexit vote, support for Donald Trump in the US and the threat of the Philippines to pull out of the UN among other things might suggest that supranationalism as a concept is struggling at this point in history.
But we don’t need to worry about that. There is quite evidently enough within the EU to worry us already.
In isolation, none of these risks appears to pose much of a threat to the bloc or its currency. Importantly, the result of this is that such risks are no longer remotely priced in. Given what we know about the political calendar over the next twelve months it is hard not to conclude that this represents too high a level of complacency.
The British Isles have been living through some historically significant weeks. The Scottish referendum resulted in the continued existence of Great Britain as a nation, but only by a narrow margin. To say therefore that politics has been interesting here lately would be an understatement. But market behaviour, on the other hand, has not been terribly volatile. The stock market has remained completely range-bound. Gilt yields did reach new lows for the year to date in August, but there were never any signs of panic. In both cases prices have been moving in the same direction as other major markets.
Where there was some more eye-catching behaviour was in the currency.
Given the focus on the pound throughout much of the political campaign this is satisfyingly appropriate (and of course its international trading symbol clearly reads: “GBP”). The sharpest move against sterling came after a weekend poll published by the Sunday Times on 7 September showed a narrow lead for the Yes campaign. Monday saw the pound fall by 0.9% on a trade-weighted basis, its biggest one-day tumble for well over a year.
We should not get too carried away here: the euro has fallen further against the dollar since mid-year and shown almost equally great volatility this month, in no small measure due to the operations of the ECB. Still, the pound has experienced a material shift over the past twelve months and this begs the question: what is its fair value?
Trading ranges are one obvious place to look for guidance. Against the dollar, sterling almost fell to parity in 1985, and peaked at over $2 in 2007. The average cable rate for the past thirty years is parked in the middle of this range at $1.64. For almost exactly one half of that three-decade period, the pound has traded within ten cents either side of the average rate, which is remarkable. At its current price of $1.63, therefore, it looks fairly valued.
The euro rate is harder to pin down on this basis. From the launch of the single currency in 1999 to mid-2007 the pound held a range of €1.40-€1.70, broadly speaking; then it weakened dramatically towards parity in 2008 and has occupied a range of between about €1.05 and €1.30 ever since. At €1.28 currently sterling therefore looks a bit toppy on a purely post-crisis view, but a bargain relative to its pre-2008 levels. (The latter also applies if one charts the pound against the old European benchmark of the Deutschmark. If the DEM still existed a pound would buy 2.5 of them, below its averages over both the past twenty and thirty years.)
Fixating on ranges, however, is the proper preserve of traders, technical analysts and all those trying to make short term sense of the foreign exchange market (there but for the grace of God … ) The long run – and textbook – point of reference is the currency’s purchasing power parity. The theory behind PPP is that the same goods and services should cost similar amounts in different countries, assuming perfect freedom of trade between them. In practice, PPP valuations are therefore calculated by reference to the relative costs of similar items of consumption and to inflation rate differentials over time. OECD PPP estimates for the equilibrium sterling exchange rates against the dollar and the euro are $1.38 and €1.11, so the pound is actually looking expensive on this measure at the moment.
More interestingly, perhaps, are the implications of PPP for long term trading ranges. Using the OECD estimates, sterling is about 13% overvalued against the dollar. When it hit the same kind of levels about nine years ago the actual exchange rate was nudging $1.80. In other words, the somewhat higher rate of inflation in the UK relative to the US over that period has shifted the PPP valuation of the pound by about fifteen cents. Another way of looking at this is that the high reached recently of $1.72 is equivalent to $1.87 a few years ago.
Over the last three decades the UK and US economies have exhibited identical average rates of CPI inflation (2.8%), which is consistent with the stability of the cable rate’s trading range over the period. Turn to Europe, however, and the picture is rather different: over the last ten years, the annual rate of CPI inflation in the UK has on average been higher than that in the eurozone by 0.8% (2.7% as against 1.9%). Going back much further is problematic as zone-wide data is not available prior to 1997 and back in the 1980s there was the matter of the separation between East and West Germany. But the twenty year average rates of CPI inflation in France and Germany are 1.5%, compared with 2.2% here in Britain.
This means that the 14.5% undervaluation of the euro against sterling on the OECD measure pits the current rate of €1.28 against a rate of almost €1.60 when the same level of undervaluation could be observed in the autumn of 2002. So while the trading range of the currency alone might suggest that the pound is priced at a rather weak level against the euro, PPP tells us that we need to shift our assumptions to take account of the material inflation differential between the UK and Europe over the last ten to twenty years and perhaps adjust ourselves to something along the lines of the post-2008 range as the new normal.
Between the long-run PPP and the short term trading view of the world are a handful of other significant forces on the exchange rate. The desirability of UK assets, the attractiveness of the country as a place to do business, the development of views on the likely future path of interest rates and (joining all these dots together) the outlook for economic growth are hugely important considerations. But the impact of PPP, and inflation, is observably apparent.
On that basis it is not quite reasonable to interpret the recent fall in the value of the pound as a conspicuous buying opportunity. And when looking at the currency diversification of a portfolio on a medium to long term investment horizon, it is worth bearing in mind the stubborn tendency of the UK economy to inflate more quickly than its major market peers over the last decade or so, especially in the case of Europe, and to consider the possibility that this might persist.
Markets barely had enough time to recover from Mario Draghi’s last “rock star” performance at the ECB before he shocked them with yesterday’s encore. Back in June he left his fans with the rhetorical question: “Are we finished? The answer is no.” Yesterday he proved it, lifting the lid on a plan for purchasing about €700bn worth of asset-backed securities while slicing another 10bp off policy rates. Only six of the fifty-seven economists and investment banks surveyed by Bloomberg expected the rate move, and the ABS programme, though trailed at the June ECB press conference, has also come surprisingly quickly.
Three months ago it looked as though Mr Draghi was playing to the crowd as much as anything. Two questions now emerge:
- Has anything substantial happened in Europe since June which has increased the need for emergency monetary measures?
- If not, how necessary are the ECB’s announcements as “open mouth operations”?
Look at the growth numbers reported in August and it is tempting to answer question (1) with a “yes”. Across the eurozone as a whole, GDP for Q2 was flat, down from an already-muted 0.2% rise in Q1. Stagnation in France was no surprise but it was a mild shock to see Italy back in recession. At the same time, headline inflation has continued to fall back with the annual CPI increase to August down at 0.3%. There has also been heightened concern in recent weeks over events in eastern Ukraine, with some commentators attributing weakness in European business investment to fears over escalating sanctions against Russia.
At the same time, however, it’s not that simple. The PMI composite indicator of economic output for the eurozone remains well into positive territory, despite the usual variation between countries, and the economic sentiment indicator (of consumer and business confidence) remains well off its 2012 lows – and indeed well above the levels associated with the three quarters of positive growth witnessed from Q2 2013. The ECB along with the consensus expects GDP to grow again this quarter, albeit at the accustomed muted rate. Even on the inflationary front much of the decline is down to cheaper energy prices: the “core” CPI rate for August, which as it excludes volatile items such as food and energy is supposed to be a more accurate reflection of the economy’s underlying price dynamics, actually rose for the second time since May to 0.9%. On balance, then, it does not seem reasonable to believe that there has been a material deterioration in the fundamental prospects for the eurozone over the last three months.
This does nothing to detract from the importance of question (2). At yesterday’s press conference (the full text of which can be read here), Mr Draghi had the following important, and in this blog’s view unarguable statement to make in the tangential final section of his answer to a question about fiscal policy:
[I]n many parts of the euro area, there are several reasons why growth is not coming back, but one of them is actually that there is lack of confidence. There is lack of confidence in the future, lack of confidence in the prospects, in economic prospects, of these countries.
It is an indisputable fact that much of the world’s confidence in recent years has relied for better or for worse on the perceived actions of central banks. The ECB understands this. And the reaction to this week’s news, together with one key longer-term trend, seems to indicate that they are getting the confidence-building part of their operation right.
First the reaction yesterday: Stoxx 50 up by 1.8% on the day, credit spreads tighter, euro back under 1.30 for the first time in over a year – in its biggest daily percentage fall against the dollar since the height of the debt crisis in November 2011 – and as for the bond market, well, that brings us on to the longer-term trend side of things.
Talking of the height of the debt crisis, back in November ’11 it cost the Italian government 7.9% to raise three-year money. A few months later, after the ECB announced its potential use of an emergency long-dated bond-buying programme, Italy was borrowing for ten years at 5.8%. Finally, just on Thursday last week, Italy raised ten year money at 2.4% and five year at 1.1%, record lows in both cases. And it isn’t just Italy. At the time of writing, two year bond yields are actually negative now in Germany, Denmark, Finland, Belgium, the Netherlands, France, Austria, Slovakia and (wait for it …) Ireland. It puts even the two-year Japanese government bond to shame, and makes the yield on our own 4% 2016 gilt look positively generous at 0.8%. All this is just excellent news, of course, if you’re an indebted sovereign looking to refinance your borrowing at the cheapest rates available in the world.
It doesn’t do to be complacent about Europe, or indeed the world economy in general. But it is encouraging that the ECB has been rising to the market’s demands for action in its own managed, but clearly credible way. European confidence in particular does indeed need all the help it can get. Rock star: play on …
An enormous amount has been written about the current situation in Ukraine and one intention of this post is not to duplicate overmuch. The politics has mostly been well covered elsewhere for instance. The economic discussion, however, has tended to focus on its direct effects, such as trade sanctions, commodity prices, and Russian asset and currency weakness. But there is an indirect effect at work that could have important economic and market consequences over the medium and long term; consequences which would have seemed very surprising only a short time ago.
The maps displayed on news websites over the last couple of weeks have tended to focus on Ukraine itself – colour-coded from time to time by language or broad ethnicity – and more latterly on the Crimea. Events further north have received less attention, yet there has been some real anxiety and sabre-rattling in the Baltic too.
On Monday, Russian forces conducted exercises in the Kaliningrad exclave on the Polish and Lithuanian borders:
Defense Minister Sergei Shoigu earlier said the snap inspections of more than 150,000 troops of western and northern military units were not connected with events in Ukraine.
Perish the thought. On the same day, a website in Poland published photographs of troop movements observed by members of the public, connecting them speculatively with events over the border with Ukraine:
Poland’s defence minister … told the TVN24 news station that “there are no movements of Polish troops which deviate from their usual routine” and that any movement[s] of soldiers and equipment are due to “routine exercises”.
Naturally. Then yesterday, it was announced that American fighters and service personnel are to be dispatched to Poland, and also that fighters and tanker planes had arrived in Lithuania to reinforce air patrols over the Baltic states. This time the connection with Ukraine was explicit. Both Poland and Lithuania are members of NATO.
This brings us on to the economic point: neither Poland nor Lithuania are yet members of the euro. Estonia joined in 2011, Latvia has just joined this year and Lithuania is set to join in 2015. Poland, however – observing the sovereign debt crisis and benefiting from currency depreciation on occasion – has been lukewarm on the matter and is not yet even in the ERM. But this week, governor of the National Bank of Poland Marek Belka said that security concerns should change the country’s thinking:
Belka said the standoff in Ukraine is increasing the political benefits of becoming part of the euro area and its $12 trillion economy, which would give Poland a seat among the “core group” of EU countries …
“There’s more influence” inside the euro area on issues ranging from defense to energy policies, Belka told reporters this week. “Even if the economic benefits today look modest, we need to make the political calculation as well.”
The euro area “is an island of stability” that “certainly looks attractive” to countries that feel threatened by the situation in Ukraine, Mario Draghi, the president of the European Central Bank, told reporters in Frankfurt yesterday, when asked about Belka’s comments.
This kind of thinking, coming from the biggest economy in the eastern part of the EU bloc, could carry over to other EU members who remain wedded to the euro only in theory. Bulgaria and Romania, for instance, have put back firm plans for joining in the past. Might these be brought forward again? The Czech Republic made weaker commitments after joining the EU in 2004 but these fizzled out; again, it may be possible for the tide there to turn. Various weaknesses have emerged as stumbling blocks to Croatia and Hungary, though European recovery should help overcome them.
On the other hand, Sweden has no plans to join and is unlikely to be subject to the same pitch of political concerns over current events in the east; and Britain and Denmark remain opted out of the project.
The policial point raised about membership by Mr Belka is of course a valid one. During a chequered visit to the UK recently, EU Commission Vice-President Viviane Reding stated her belief that “the eurozone should become the United States of Europe.” And in connection with Ukraine, Commission President Barroso – in addition to his commitment to supporting the country with €11bn of aid – said only yesterday:
Not only we have reiterated the European Union’s commitment to signing the Association Agreement … we have also decided, as a matter of priority, that we will sign very shortly the political chapters. This means notably the general principles, the part on political cooperation and the Common Foreign and Security Policy (CFSP) of the Association Agreement. This will seal the political association of the European Union and Ukraine.
This might not mean too much in practice. After all, how many divisions has the EU Commission? And there are several countries – including Finland, who has a peaceful shared border with Russia – which are signed up to the EU and the euro and are not members of NATO. Still, one can see why some in Poland and elsewhere might be encouraged by this kind of thing, and Vladimir Putin and others rather less enthralled.
To summarise: negative sentiment on euro membership arising from the sovereign debt crisis has abated with the crisis itself. Further, it is clear that an unwitting consequence of the new crisis in Ukraine has been to make membership seem more attractive, at least to some.
Over the medium term this could entail market convergence as seen in the late 1990s: the extra yield on ten year local currency debt issued by Poland compared to euro-denominated debt is 1.5%, for example, and this gap would be expected to close.
Over the longer term, as the eurozone in particular gains momentum in its quest for “ever closer union”, the position of the dwindling number of EU states outside it would look increasingly anomalous. The economic consequences of political change taking place as a result of this, especially here in Britain, are unpredictable.
Towards the end of July, Mario Draghi, President of the European Central Bank, promised to do “whatever it takes to preserve the euro.” For a few weeks, equity markets pushed slowly higher, the euro recovered some of the ground it had lost since the spring, bond market panic began to subside and observers watched nervously for the actual ECB policy.
Yesterday it was announced. The eurozone’s central bank will buy as much short dated government bond debt as it takes “to prevent potentially destructive scenarios.”
There are conditions attached. Bond purchases will be “sterilized” by offsetting the amount bought with liquidity reductions in money markets; in other words, the eurozone’s money supply will not increase. So this is not “quantitative easing”. In fact it can be seen as a corollary to Draghi’s last big move: extending ECB lending to the banking system out to three years last December (an operation which saw interest of almost half a trillion euros on day one).
What makes this necessary, of course, is the power of the bond market to kill economies and the impact this has had on confidence – in the more troubled eurozone countries, and across the world. Thus far Draghi’s announcement has served to consolidate rallies in “peripheral” eurozone debt: 5 year Portuguese interest rates have fallen from over 11% when he made his July announcement, to 7.1% on Wednesday, to 6.1% today; the 2 year yield in Spain has more than halved from over 6% to 2.8% over the same period; Italy’s ten year benchmark has come down from 6.5% to just over 5% – and so on. With luck, this will help turn confidence around in the real economy and allow the world recovery to pick up a little steam.
With luck, because this is far from being a foregone conclusion.
Firstly, there are those with the strongly held conviction that the euro is a concocted deadweight born of an aberrant political vision, irrevocably destined to collapse. For them, Draghi has wielded “a pea shooter rather than a bazooka”; and whatever anybody does now or in the future, “the eurozone is simply doomed.” Restoring confidence where there was none to begin with is an impossible task.
Secondly, confidence is a skittish thing. We saw this last autumn, when positive market reaction to the October talks in Europe was derailed completely by the announcement of a referendum on their outcome in Greece. That country’s emergency creditors are in Athens again this weekend, and will decide over the next few weeks whether or not to advance a further bailout tranche (due next month). Another disaster could very well impact sentiment again.
So good luck to Mario Draghi – but he’s not the only game in town.
This blog observed early in the year that economic data and market confidence were being pulled in two directions. On the one hand, Europe continued to drag along and threaten financial cataclysm. On the other, fear over a double dip recession in the US was unwinding rapidly and signs of improvement in the labour market in particular were giving markets encouragement.
Yesterday’s strong open in New York lifted European markets well above the levels they had reached while anticipating and reacting to the ECB’s rate decision and press conference. This was partly due to a stronger than expected US service sector growth indicator and stable data on unemployment insurance claims. Overnight, the combination of good news from the world’s most significant developed economies saw China’s Shanghai Composite Index rise by almost 4%.
The ECB got all the limelight yesterday. The defence of the eurozone from collapse remains a significant driver of market behaviour. But the failure of the US to grind to a halt is important too. Ultimately, we will know that confidence has truly returned when ECB press conferences aren’t making headlines all over the world.
Yesterday, the ECB announced that it was keeping eurozone interest rates on hold at 1%. ECB President Mario Draghi made the remark at the following press conference that “there are tentative signs of stabilization of economic activity at low levels”.
The language was cautious, and Draghi also noted that the economy continued to face serious risks from the debt crisis. But there were another two bright spots of news this morning to suggest that his heavily guarded optimism is justified.
Firstly, Italy sold €4.75bn worth of government bonds, the maximum required, on top of the €12bn of one year financing she raised in the money markets yesterday. The bulk of this – €3bn – came from a reopening of the 6% 2014 at a yield of 4.83%, down from the 5.62% paid on the same bond in December and much lower than the 7.89% paid on issue the month before. This blog has long highlighted the importance of the question of whether or not bond and money markets remain open to Italy (and others). That they are open at levels which have become significantly more affordable is a bonus.
The ECB may be able to take some credit for this. Its programme of 3-year lending to banks, which saw almost half a trillion euros of interest when it began just before Christmas, has given them the incentive and the firepower to increase their bond market exposure substantially.
Be that as it may, it can certainly take credit for today’s second bright spot: the 3.9% increase in eurozone exports which saw November’s seasonally-adjusted trade surplus for the region jump to €6.1bn, a 7½ year high. Eurozone interest rates may only have fallen by 0.5% over the last two months but the 4% fall in the value of the trade weighted euro this brought with it is proving to be as welcome as might have been hoped.
As ever, we should note that there are reasons to be gloomy. After Germany reported a small contraction in output for the fourth quarter, it is certain that European growth stalled into the end of the year and further weakness this quarter could see the eurozone experience a technical recession. Agreement on restructuring Greek debt has yet to be reached, and the ratings companies have already warned of further sovereign downgrades to come. Outside of Europe too, the economic picture remains mixed and markets morose amid a slew of finance sector profit warnings and redundancies.
Nonetheless, predictions of out and out disaster for the eurozone are looking increasingly stretched. It is far from being in the best of health, but reports of its death are an exaggeration.