• EMU. The eurozone entered 2007 on a stronger footing than originally anticipated. Hence, we are raising our GDP forecast from 2.0% to 2.3%. Even though GDP growth will be slightly weaker than in the previous year (+2.8%), it remains above potential.
  • Germany. The correction in Q1 GDP growth following the VAT induced advance effects in late 2006 is not as pronounced as initially feared. Combined with a solid labor market underpining consumption and brisk investment activity, this justifies an upward revision of German GDP growth to 1.6%.
  • Italy. At 1.7%, the Italian economy will also post stronger growth in 2007 than initially expected. The recovery now appears well entrenched. However, the growth spurt towards the end of last year will be followed by a technical counter-reaction at the beginning of this year.
  • ECB. With prolonged above-potential growth and ongoing rapid money supply expansion, the risk is increasing that the European Central Bank will continue to tighten in the second half of 2007.
  • Fed. In contrast to that, Bernanke has fueled new rate cut speculation with his muted growth and optimistic inflation outlook. We are, however, sticking to our expectation of unchanged key rates throughout 2007.

Further topics:

  • Weekly Comment: Financial market risks – we have to address them.
  • US: Tightening of credit standards to weigh on housing.
  • Bank of Japan: Rate hike as early as next Wednesday.
  • Bank of England: Next rate hike is only a question of time.
  • Data outlook: ifo & ISAE business climates to deteriorate; US consumer prices to be roughly unchanged.
  • Market outlook: Yield curves remain flat; EUR well supported.

WE DO HAVE TO TALK ABOUT IT!

Sometime silence really is golden. It was relatively easy to guess that the G7 meeting held in Essen last weekend would not produce any market-shocking rhetoric, but the part of the final statement referring to currencies seemed like an unusually clumsy signal of how divided the G7 is. The statement helpfully pointed out that growth is holding up well in the US, doing great in Europe, and is well-entrenched in Japan, and expressed confidence that financial markets would factor this growth outlook into their risk assessments, being wary of placing one-way bets.

The intended message was obvious: Japan is growing too, so you should not assume that the yen will forever weaken against the euro. The catch of course is that the markets have taken note of Japan’s growth for quite some time already, and meanwhile have been able to also take note of the fact that inflation is not performing in as convincing a manner, and that the BoJ as a consequence appears more cautious than was envisaged. Ironically then, with BoJ rates low, the solid growth environment outlined in the G7 statement gives the perfect backdrop for the very carry trades that the statement was meant to discourage. Unsurprisingly, the EUR-JPY rate had already moved on to new highs within a few days of the statement.

The problem here is obvious: Europeans worry about the weak yen, the US worry about the weak yuan, and China and Japan worry about maintaining their pace of GDP growth. Not much room for coordination here, and hence not much for the markets to worry about.

Beyond the FX rhetoric, the G7 messages were mostly about risk, with repeated references to carry trades, one-way bets, and hedge funds. These concerns are not new, of course. Policymakers have been worried for quite some time that conditions in financial markets might be too good to last, and the key concerns/alarm bells are well known: extremely low levels of volatility across the board, from the VIX (cf. chart) to implied volatilities in key exchange rates; extremely compressed spread levels for both high-yield corporate bonds and emerging markets sovereign bonds; seemingly stretched valuations in most asset markets, including selected real estate markets; and last but not least, the dramatic increase in the volume of CDOs and other structured products.

Against the background of persistent macro imbalances, this makes for a very high level of genuine uncertainty. Note for example, that opinions are still divided on the role played by structured products and by hedge funds: some believe they pose a serious and underestimated risk to global financial stability, whereas others think they actually play an important stabilizing role. The jury is still out, and given that things so far have worked out well, there is an understandable reluctance to intervene with serious additional regulation.

From our perspective, we clearly do recognize that with the current low spreads and tight valuations, risks to asset prices are generally skewed to the downside. At the same time, however, we believe that in our baseline macroeconomic scenario these conditions are likely to be maintained through the remainder of the year: as fears of a US hard landing get fully priced out and the ECB reaches the peak of its tightening cycle, there will be little risk left of a sudden withdrawal of liquidity and the macro backdrop should be sufficiently reassuring for yield hunting behavior to continue.

Short-term, temporary spikes in volatility are likely however, which suggests keeping an eye out for possible flashpoints—the increased rhetorical tension surrounding Iran might provide one in the very short term - to tactically hedge exposure, as we are currently recommending on our Emerging Europe trading strategies.