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Friday Notes

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Europe has grown out of recession

Fri, Oct 2 2009, 11:20 GMT
by UniCredit Research

UniCredit Group

• Stragglers. While the big two had achieved the economic turnaround as far back as the spring thanks to the earlier & stronger recovery of global trade as well as the massive monetary and fiscal policy stimuli, the remainder of Europe (except for Spain) now appears to be following suit. The recession has now run its course for the European stragglers, too.

• Italy. That also holds true for the third-largest economy in the euro zone. For the summer quarter, we do, however, expect economic output to “merely” stagnate; but it should be the current quarter before real GDP returns to a growth path. In the first half of 2010, however, the Italian economy will lose traction again, once the economic policy impulses subside and global trade loses momentum. We do not, however, expect a renewed slide into recession (pages 3-4).

• United Kingdom. The development is similar on the other side of the Channel. The most severe recession of the post World War II era is also over in the UK. Manufacturing is already expanding again, and the housing market is staging a gradual recovery. But there too, the upswing is not yet sustainable.

• Central banks. For that reason, it is too soon for central banks to already consider an exit strategy. Nevertheless, the most recent development shows that the combination of unconventional measures and a “zero rate policy” of the ECB and Bank of England is gradually having an impact (pages 2 & 5-7). Financial markets are normalizing step by step, investors are increasingly regaining confidence in the economy as a whole and are prepared to assume more risks.

• Further topics:

  – Weekly Comment: ECB 1Y LTRO, a sign of normalization (p. 2).

  – US: Deleveraging, without a sharp rise in the savings rate (page 8).

  – Germany: New government faces a very difficult task (page 10).

  – Data outlook: EMU industrial production on the rise (page 12).

  – Market outlook: EUR takes a breather (page 18).

ECB LTRO – an important signal of ongoing normalization

Demand at this week's 1-year refinancing operation was EUR 75.2bn, at the lower end of the (wide) range of market expectations and well below the EUR 442bn of the previous and first auction. The number of bidders also dropped sharply to 589 from 1125 in June. This is a tangible and encouraging sign of ongoing normalization in financial markets, which should add further fuel to the recovery in risk appetite, supporting equity markets and the EUR. The short end of the curve came quickly under pressure, with yields on 2Y Bunds moving up by 6bp on the news. The ECB has clearly reiterated its commitment to keeping in place its liquidity support, and given the extremely benign inflation outlook will refrain from signaling an early exit strategy that could put sudden pressure on rates and on the EUR. The normalization of market rates will therefore likely be very gradual, and the next few months will continue to benefit from a combination of ample liquidity and improving activity and financial sector indicators, but with a mix that should favor equities and other risky assets more than short-term bonds.

Over the last few months, absorption of ECB liquidity had declined by about EUR 200bn, as demand from financial institutions fell short of maturing liquidity operations. As demand this week clocked in at only EUR 75bn, it seems clear that eurozone financial institutions are reducing overall demand while at the same time prudently lengthening the duration of their liquidity. This reduced demand for liquidity, in my view, signals greater confidence in the economic outlook, driven in large part by improved visibility and predictability: the stabilization of the macro outlook on the one hand, and the ECB’s reiterated commitment to maintaining liquidity support on the other, have converged to make the outlook for financial institutions much less unpredictable, thereby reducing the precautionary demand for liquidity. The recent rise in asset prices has also helped: the IMF has just lowered its estimates of overall financial sector losses by USD 600bn.

The money market is of course still far from full normalization, and displays an increasingly marked differentiation between more solid institutions, which have easier access to liquidity from a wider variety of providers, and lower-grade ones which still rely almost exclusively on the ECB (as Aurelio Maccario has recently pointed out). But it is important to remember that the ECB’s commitment to keep the liquidity support in place is crucial for all players, because it reassures banks that long-term liquidity will remain readily available even in case of further unforeseen shocks.

The ECB, for its part, remains unmistakably outspoken on this point: President Trichet reiterated the other day that an exit strategy is still premature, and other Governing Council members have re-affirmed an outlook of weak growth and subdued inflation for the next 15 months at least. And following words with deeds, the ECB has refrained from applying a spread over refi at this week’s auction.

The main criticism could be that some of the liquidity will be either re-deposited with the ECB itself, or invested in carry trades. The use of the deposit facility, however, seems to reflect in large part the behavior of lower-grade financial institutions which are willing to pay a premium to keep their liquidity readily available at the ECB. As Trichet hinted at the last press conference, this is a sign of the current dichotomy in the market, not ideal, but still a step forward compared to the days of complete paralysis. As for carry trades, they are also helping to shore up banks’ balance sheets, thereby laying a stronger foundation for a re-acceleration of credit growth as economic activity begins to recover and banks gain confidence that non-performing loans will not surprise to the upside compared to the levels built in loan-loss provisions. That, in the end, is one of the reasons why central banks lowered short-term rates to zero and steepened the yield curve. An additional side benefit of carry trades, of course, is that they are helping governments finance their growing fiscal deficits, given that some government bonds offer a yield pick-up of some 300 basis points. Finally, we should note that the much reduced demand for liquidity at this week’s auction also indicates that a number of carry trades are now considered considerably less attractive.

Looking forward, I expect liquidity to remain ample and rates relatively low in the coming months, again in line with the ECB’s reassurance. The ECB’s recent “strong dollar” rhetoric (Trichet this week) also points in this direction, as the bank is well aware that an early withdrawal of liquidity would immediately spark expectations of refi rate hikes and drive both market rates and the euro up quickly. In addition, this week’s CPI data confirmed that inflation pressures are nowhere on the horizon: consumer prices declined 0.3% yoy in September, and we expect another negative reading in October, with price growth returning into positive territory only in November. If the market normalization that we are witnessing continues, however, we will see short-term rates rising steadily in the coming quarters, to come in line with the refi by year-end.

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Published on  Fri, Oct 2 2009, 11:25 GMT