There is still a lot going on in Europe:
  • Silvio Berlusconi faces the budget vote. If he loses and refuses to go, there is talk of a confidence vote, followed by a national unity government to implement the austerity programme and then call an election, perhaps under Mario Monti, a former European Commissioner. A poll yesterday by IPR Marketing for Repubblica showed the centre left leading Berlusconi’s centre-right coalition by 45.5% to 35.5% among voters who expressed an opinion (a large proportion of voters was undecided). 
  • ECB bond purchases amounted to EUR 9.5bn last week, a relatively high number. Total purchases now stand at EUR 183bn.
  • The EFSF did the EUR 3bn bond issue (to fund Ireland’s bailout) that it postponed last week at a spread of 177bps to Bunds. As a comparison, its first bond issue was conducted at a spread of 51bps.
  • There are reports that banks are offloading PIIGS debt — presumably because they are increasingly being punished by the markets for holding it. With Italian bonds rising, there is a danger that margin requirements — i.e. repo haircuts — could be raised by LCH.Clearnet, which would mean the bonds were of less use to banks as repo collateral. 
  • PASOK and ND are still discussing who is to head Greece’s new unity government.
  • France has announced EUR 65bn of cuts over five years, beginning with EUR 7bn in 2012 (compare German tax cut of EUR 7bn announced over the weekend). 
There is some more information about why the oil price is rising — an IAEA report on Iran is raising tensions in the market. From Nightwatch: “International Atomic Energy Agency (IAEA) – Iran: A report by the IAEA to be released within a week will make the most detailed charges to date that Iran’s nuclear program is in fact a nuclear weapons program. Sources said that the report will include new information on efforts by Iran to develop technologies to build a nuclear weapon, including computer models of a nuclear warhead. The new report is expected to make more explicit charges that Iran is developing nuclear weapons than previous reports.” It is not clear whether this report will use new data or will be a reassessment of existing data. Stories like this tend to raise expectations of Israeli airstrikes on Iran. Market people love to predict such things, because they like to feel like political insiders and contrarians at the same time. I am always sceptical of the possibility of airstrikes on Iranian nuclear facilities because Iran’s response could be positively demented. So far scepticism has proven to be the right attitude.

I did some thinking on two subjects yesterday, prompted by correspondents: the European situation and interest rates.

On interest rates:

There are several strands to bring together on interest rates:

  • The US economy is in a liqudity trap, so it makes sense that interest rates are low. This was the basis on which I thought it was worth having a yield-curve flattener back in the Spring. However, while this idea tells us that rates are unlikely to return to pre-crisis levels and is consistent with the downward trend in real interest rates in the past couple of years, it does not predict shorter-term gyrations in the market, and why real rates have only now hit zero.
  • Market expectations drive rates: as a recovery seems more likely, interest rates rise.
  • The second point above is true partly because the Fed is expected to raise rates if the economy grows. But that effect is muted at present by the Fed’s stated expectation that rates will not rise until mid-2013.
  • The Fed has been successful at convincing the market that it will fight both inflation and deflation effectively.
  • A consequence of the Fed’s actions is that nominal rates are held down while inflation expectations tend to the Fed’s implicit inflation target. This means that real rates are low.
  • However, this cannot be the whole explanation.
    • Rates moved to about their current lows in early August, before the Fed stated its expectation that rates would stay low until 2013.
    • Perhaps markets anticipated something like the Fed’s action. But I have used the Eurodollar curve and 10-year rate to calibrate a simple model that shows that the position in April of this year, before the recent decline in rates, was consistent with short-term rates rising slowly before levelling out at 5% in 2016. Applying the same trajectory for short-term rates from 2014 onwards (i.e. starting the increase after 2013), and using the current futures curve for 2012 and 2013 rates, implies a 10-year rate of about 2.7%. The actual rate is 2.03%. In other words, there is more than the Fed’s action in the most recent decline in rates.
    • Working backwards and using the same model, current rates are consistent with the April trajectory if rates begin to rise some time in late 2014.
  • It seems that some event in July convinced the market that the future path of interest rates would be much flatter than it had previously anticipated, before the Fed instituted the “2013” language. That event, I think, was the downward revision of past US GDP in late July. It convinced the market that the US was in a liquidity-trap-like position. However, thanks to the Fed’s two rounds of QE, the market remained convinced of the Fed’s ability to hit its long-term inflation target. Thus real interest rates fell to new lows.

I am not sure what this analysis tells about the future. Is the yield curve leading or lagging GDP? I do not think the answer is clear, and this is another reason to be cautious of the curve as a recession indicator at present.

On Europe:
There is no sovereign-debt crisis — what we are seeing in Europe is the kind of crisis you get under a gold standard (and which used to be solved by central banks making emergency gold loans to each other). The Eurozone periphery cannot obtain enough private capital to finance its current account deficit, and that is the fundamental problem. The present situation is worse because there is no possibility of even a one-off devaluation. Therefore there are five solutions: 1) private capital is replaced by public capital — core governments finance peripheral governments; 2) internal deflation in the periphery closes external imbalances; 3) inflation in the core closes external imbalances; 4) euro exit; 5) unlimited lending to governments by the ECB.

Governments in the core will not accept 3), and peripheral populations will not accept 2). 4) is essentially impossible without a strong government able to impose capital controls overnight and make it a surprise. The ECB will continue to resist 5) and therefore push governments towards 1). If we reach a stage where core governments will go no further, then the choices will be 2) (by the mechanism of default and banking collapse) or 5).

I think the correct model to apply here is one in which the parties act in their own interests. At present, it is in the interest of core politicians to continue to move towards 1), because European solidarity is a strong force in Europe. I think there is a long way to go before that changes, and so on an investable horizon I expect further expansion of the EFSF/ESM. At the same time, as the price of this, peripheral governments will attempt 2) and Europe will have a recession.

As time goes on, the failure of 2) is going to become obvious. That will mean further bailouts are required, and core governments will provide them as long as European solidarity wins more votes than fiscal isolationism. If that balance changes, the choice will be 2) or 5) — and in that situation, the ECB will act in its own interest and choose 5).

Data:
German IP -2.7% d.e. Sep. More evidence of weak German economy.
US consumer credit 7.45bn b.e. Sep. No surprise given the falling saving rate and weak personal income growth.
UK BRC retail sales monitor -0.6% Oct. 
Australia trade surplus fell, d.e., Sep. Still quite wide.
German trade balance b.e. in Sep, showing quite a high surplus. French trade deficit was wider than expected, and quite wide. European rebalancing is yet to happen.
UK manufacturing production 0.2% a.e. Sep. IP 0% d.e.
Next 24 hours:
UK NIESR GDP estimate
Rash of China data
UK trade balance
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