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Euro Compass

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The credit threat on the green shoots

Wed, May 13 2009, 14:58 GMT
by UniCredit Research

UniCredit Group

• In the first quarter of 2009, the euro area experienced the worst downturn ever. After the gloomy March IP numbers, we have revised our Q1 GDP forecast to -2.3% q-o-q, with some downside risks. Again, investment and exports were the key drivers of the contraction whereas the decline in consumption was presumably relatively contained. Incoming evidence suggests that in Q2 the pace of recession should slow substantially: we keep seeing GDP at -0.6% q-o-q with probably some small upside risks. However, the bottom line is unaltered: the recovery will be very gradual and won’t occur before the first quarter of next year, mainly because of the lagged and timid fiscal policy response.
• Meanwhile, inflation is about to make another sizeable move downward. In May, HICP will likely fall close to zero driven by an energy-related base effect. In June, it will turn negative and in July it will hit its bottom at -0.5% y-o-y. Moreover, underlying momentum – as captured by core prices – points south as well and will continue to do so for a long time. A gradual pickup in headline inflation is expected after the summer once the base effect on energy will turn unfavorable. However, our view on core prices make us think that headline inflation won’t rise back toward 2% over the whole forecast horizon.
• At its May meeting, the ECB cut the refi rate to 1% and announced it will start a covered bond purchase program worth EUR 60bn. Other measures to ease liquidity conditions and tight lending were the extension to 12 months of the “fixed rate full allotment” procedure and the inclusion of the European Investment Bank (EIB) among its eligible counterparties. Although Trichet avoided making any pledge on rates, we do not see any reason to change our call for a 1% refi rate floor. In any case, another small rate cut wouldn’t occur until the end of the summer. The money market is aligned to this view.
• We continue to pay a great deal of attention to the credit market evolution. First, we demonstrate that until the end of last year the lending slowdown was mainly demand-driven. However, the sizeable recession of the past months is being felt on banking books as well, and losses and provisions on loans will lead banks to undertake very cautious lending policies. If recent IMF estimates on further losses that European banks have yet to suffer are correct, then our guess is that eurozone banks will reduce their loan supply by roughly EUR 250bn.
• The Fed and BoE QE programs have so far proved unable to significantly affect long-term yields. We accordingly remove this factor from our FI outlook. While yields have room for a near-term rally, this would be temporary, relatively limited in size, and mainly related to a change in economic sentiment. In this respect, we think bonds offer some upside in the near term. The risk reward profile becomes very unfavorable in a medium-term perspective. Short-term rates should offer a good protection vs. rising yields as no rate hike is in sight.
• Central banks’ decision whether to join or not the QE club has now become a key driver for FX majors: hence, ECB reluctance to follow a standard QE policy should contribute to increasing the EUR-USD upside potential above 1.40 in the medium term. We revised upwards our EURUSD forecasts to 1.40 by Q4-2009 and to 1.45 by Q1-2010, also reflecting more risk appetite and Fed’s unwillingness to start tightening soon.

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Published on  Wed, May 13 2009, 15:01 GMT