What is Going On?

The markets do not make any sense. As it looked like ND and PASOK were likely to win in Greece, there was a general risk-on rally, but Spanish yields also rose and the 10-year is above 7% this morning. Why are markets so sanguine about Spain? I suppose you could argue that the tail risk of Greek euro exit is diminishing, and markets therefore ought to rise a bit; but European breakeven inflation has also rallied strongly in the past week, and the German repo spread — the difference between overnight lending and repo, which I am using as an indicator of the demand for high-quality collateral — has had its biggest inward move for some time. If the markets think that Spain is heading for disaster, then why are European inflation expectations rising and why are banks less desperate for super-high-quality collateral?

These observations can be made coherent in the following way: the markets expect Spain to be driven into a bailout, but for this to have little effect on economic growth. That is not actually an unreasonable view. The EU has the institutions to make large loans to Spain, and is moving towards a framework that would allow loans, or transfers, to become a permanent feature of the EU. It also seems to be the ECB’s view, since that institution is deliberately driving Spain into an EU plan (by refusing to buy Spanish bonds).

If this view is correct, then the Greek election ought to be a turning point for the markets. The risk of Greek euro exit is likely to recede (contra Paul Krugman, who expects imminent exit — I do not think he realises the pull of the European project http://bit.ly/LqESOJ). Given how large a disaster such an exit was generally considered to be, its disappearance from the set of likely futures should be very positive for the market.

Of course, nothing is foolproof. It could just be that the markets have had a blip, and the Spanish situation will drive them down again; or it could be that some other factor — such as disappointment with whatever action the Fed decides to take at its coming meeting — could drive the markets down again. But I think that the big danger in recent weeks has been the danger of Greek exit. I have consistently argued that it would not happen, and now I think the likelihood is fast receding; this strikes me as being a very good argument for buying risk assets.


I keep thinking about Japan. Large-cap equities are not wildly expensive (for a change) and very low compared to their own history and to their normal relationship with the mid-cap Second Sector index. CDS spreads are narrowing; the BoJ balance sheet is slowly expanding; deflation-fighters are joining the BoJ board. Today it has been announced that Noda has allowed two nuclear reactors to be switched on, and if this trend continues then the current-account deficit should begin to close. And Japan’s economy seems to be doing well — at least, as judged by the OECD leading index, which continues to move strongly upward. Economic surprise has recently been negative, as it has been around the world, but unlike in the US or Europe it is showing signs of stabilisation. Most importantly, real rates have turned decisively negative. I really think it could be time to buy.

Negative Real Rates

Do negative real interest rates have the stimulative effect on an economy that one would expect? The evidence from the US is that they do. This morning I have been looking at real gross private domestic investment minus change in private inventories (as a gauge of underlying investment expenditure). After troughing in 2011 Q2 at 4.5% YOY, it has quickened in the past few quarters and in Q1 stood at 8.5% YOY, the fastest rate of growth since 2000 (http://bit.ly/LqJbJH). This quickening has coincided with the decline in US real interest rates into negative territory.

Turning to Japan, real rates there, as implied by 7-year index-linked bonds, have fallen a long way in the past year, into negative territory, and this should provide a significant stimulus to the economy.


  • US Empire State index 2.3 d.e. and fell. A sharp fall for the current month.
  • US capacity utilisation fell to 79% d.e. May. Remains on an upward trend.
  • US industrial production -0.1% d.e. May.
  • US prelim. Michigan sentiment fell to 74.1 d.e., undoing the gains of the past two months.

This Week

  • G20 meetings (Mon and Tue)
  • Australia MPC minutes (Tue)
  • UK CPI (Tue)
  • German ZEW (Tue)
  • US building permits (Tue)
  • Japan monetary policy minutes (Wed)
  • Japan trade balance (Wed)
  • UK employment data (Wed)
  • UK MPC minutes (Wed)
  • FOMC statement and press conference (Wed)
  • Global flash PMI’s (including US) (Thu)
  • Eurozone current account (Thu)
  • UK retail sales (Thu)
  • US existing home sales (Thu)
  • ECOFIN meeting (Fri)
  • German Ifo business climate (Fri)