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Friday Notes

58801570-c9aa-4b87-87fa-b09a57481651

16

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W−shaped recovery increasingly probable

Fri, Jul 3 2009, 12:08 GMT
by UniCredit Research

UniCredit Group

• Sentiment. Despite some setbacks, most of the leading and sentiment indicators continue to point north. The US manufacturing ISM, for example, jumped to a level now indicating expansion in the overall economy. As a result, the recession probability fell below 50% for the first time since summer 2008 (cf. chart).

• Hope. The US NBER must, however, wait for more hard data before it can declare the recession to be officially over (pages 4-6). Nevertheless, recent developments support our expectation that the US economy will return to growth in the course of the second half of this year.

• Clunkers. The reason for this is the exceptionally rapid destocking, which is now leading to a pick up in production again. At the same time, fiscal stimuli programs will start to have their impact. The "Cash for Clunkers" plan, the auto scrapping premium based on the German model, is expected to add one quarter of a percentage point to GDP growth in the second half of this year, possibly even more (p. 7-9).

• Flash in the pan. The experience of Germany, however, shows how rapidly this flash in the pan fizzles out again (p. 10-11). It is nothing more than borrowed growth that will then be all the more painfully missing in 2010. A W-shaped recovery in the US is, therefore, becoming increasingly probable, also because the deleveraging process in the private sector is not finished yet. A self-sustainable growth path looks different!

• Further topics:

  – Weekly Comment: Porte-parole privilege (page 2).

  – EMU: No quick exit from recession (page 12).

  – Data outlook: More new orders in Germany; US trade balance slides deeper into the red again (page 13).

  – Market outlook: EUR and govies back in quieter waters (page 20).

Porte-parole privilege

The ECB’s press conference, which began as US non-farm payrolls dropped another 467k, turned out to be significantly more interesting than expected in at least one respect: just as economic activity begins to stabilize and financial market tensions abate, the ECB seems to become increasingly concerned about the risk of a credit crunch. Together with its cautious view of the recovery prospects, this supports my view that interest rates will remain on hold well into next year. Mr. Trichet confirmed that the current stance on both interest rates and “enhanced credit support” is appropriate, but it is clear that the bank stands ready to do more on either front if needed. The ECB talks the talk of the Bundesbank, but it walks the walk of the Fed and Bank of England. Another reason why the ECB is not in any hurry to deploy an exit strategy is that it is confident that it will be able to exit very quickly once it decides to. Trichet confirmed yesterday that all policy actions have been designed especially so that they could be unwound quickly – including, as I have noted in the past, the strategy to push market rates to zero while holding the refi at 1.0% and that of relying mostly on refinancing operations rather than on asset purchases. The ECB is rightly satisfied with the success of the 12-month refinancing operation, but with banks happy to pay a hefty 75 bp charge to redeposit much of it, there is clearly no certainty that the liquidity will be promptly passed on to the real economy. Individual Governing Council members have voiced different opinions on how the ECB can push banks to lend, or by-pass them if they do not. Mr. Trichet yesterday invoked “porte-parole privilege” to avoiding commenting on the state of the internal debate, and instead deployed a very polished and articulated moral suasion on banks, something that is becoming a favored tool in the central bank’s arsenal.

The ECB’s prudent attitude will keep short-term rates well anchored, with room for a further moderate decline in short-term Euribor rates, whereas the long end will remain exposed to risks coming from (premature) inflation fears and bond supply concerns. The great bear flattening trade will have to wait for quite a while. Just as economic activity has begun to stabilize and financial market tensions abate, the ECB seems to become increasingly concerned about the risk of a credit crunch. I have highlighted this trend over at least the last couple of months, but yesterday’s press conference was especially interesting in this regard. ECB President Trichet was quite clear in stating that:

1. While it is difficult to disentangle the joint collapse in credit demand and supply, it seems likely that supply restrictions are now playing a role.

2. The recent decisions to launch 12-month refinancing operations and covered bond purchases are aimed at counteracting credit supply constrictions, and the ECB sees the measures deployed so far as adequate.

3. The ECB has stepped up its moral suasion, calling on banks to lend the liquidity on to the real economy, but also to strengthen their capital base including by taking recourse to the support measures offered by governments.

In this regard, Mr. Trichet referred to the latest Financial Stability Review to note that the ECB is well aware of the pressures bearing on the eurozone’s banking system – even though it has a less pessimistic view than the IMF on the matter.

Moral suasion has recently come to play an increasingly prominent role in the ECB’s strategy. Mr. Trichet yesterday offered the most polished and articulated version, explaining that the ECB’s own efforts in providing enhanced credit support must be matched by governments and private banks in order to be successful. Mr. Bini Smaghi had recently voiced a rather sterner and somewhat disconcerting warning, saying that “the appropriate authorities” should ensure that banks on-lend the liquidity provided by the ECB.

This kind of “enhanced moral suasion” is pragmatic but somewhat questionable. To the extent that banks are tightening lending criteria in response to a deteriorating macro environment and the corresponding rise in projected default rates, pressing them to lend more is tantamount to a call to imprudence. Of course, banks would be carrying out a social responsibility in helping to soften the recession, but we should remember that while the ECB provides the liquidity, the banks still shoulder the credit risk. The next step in the logical chain is the ECB’s recommendation that banks strengthen their capital position with the help of governments, if need be – obviously a rather sensitive issue.

Mr. Trichet invoked “porte-parole” privilege during the Q&A, rejecting requests to comment on statements by other Governing Council members, notably Mr. Weber, who stated that if banks do not channel the additional liquidity to the real economy, the ECB would have to bypass them. His reluctance is understandable, as this is very uncomfortable territory for the ECB. By-passing the banking system would presumably imply direct purchases of commercial paper and corporate bonds. In an environment of rising default rates, that would run counter to the ECB’s desire to limit the risk on its books – indeed, Mr. Trichet said yesterday that the bank had decided to focus on covered bonds because they came with a double-guarantee and therefore carried very little risk.

The ECB’s cautious assessment of the financial sector’s situation is mirrored by an equally prudent view of the macroeconomic outlook: the steady sprouting of new green shoots has not moved the ECB away from its view that positive growth will only return by the middle of next year. The bank sees risks to its growth outlook as balanced, with the risks of a stronger or more protracted feedback from the financial sector, of rising unemployment and oil prices, of protectionism and a possible disorderly correction of global imbalances matched by the hope for a stronger-than-expected impact of the policy stimulus or a faster improvement in confidence.The ECB’s view on inflation is also unchanged, with price developments expected to remain dampened over the policy relevant horizon. As expected, Trichet repeated that the drop of inflation into negative territory which began last month will be temporary and is not relevant from a monetary policy perspective. He also stressed that inflation expectations remain well anchored, referring in particular of projections of 5-year inflation in the Survey of Professional Forecasters (SPF), so that the bank is confident that its objective of price stability will be met over the medium term. I tend to agree, but, as I have pointed out in the past, the real test of inflation expectations is coming now, and while the SPF is reassuring, consumers' inflation expectations are more of a concern: they have already dropped sharply, and will likely fall further as we record a few months of negative headline inflation. Two additional minor points here: First, while risks to growth are seen as balanced, the growth outlook is seen as a downside risk to the inflation outlook – I think this is exactly right, given the projected widening in the output gap and consequent impact on core inflation. Second, the upside risks to inflation still sound unconvincing to me: Trichet mentioned commodity prices and the rise in indirect taxes and administered prices which will be needed for fiscal consolidation, but both of these factors in my view would imply if anything an even more sluggish recovery and therefore muted price pressures.

The bottom line is that policy is seen as appropriate, both as regards the level of interest rates and the asset purchases program – although Trichet repeated that there is no precommitment, and in particular that 1.0% is not a hard floor for the refi rate. I therefore remain convinced that rates will be on hold for a long time, well into next year. The ECB is in no hurry to begin unwinding the stimulus also because it knows that it will be able to do so very quickly once it decides to – as Trichet noted yesterday, its policy has in fact been designed with an exit strategy already in mind.

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Published on  Fri, Jul 3 2009, 12:14 GMT