No, this is not quite 2011/2012 – less dramatic, but ultimately more troubling -------------------- There were a lot people out there declaring a return to the eurozone debt crisis. As in every crisis, there is a tendency to focus on the last one. In 2007/2008, people focused on the hedge funds, when the trouble came from ordinary banks (and Lehman, of course). Now we are focusing on sovereign spreads – when the real problem is a fairly uniform decline in growth and inflation in the eurozone. What has returned is market volatility. Yesterday it was of the down and up variety. Stock markets recovered most of their losses of the day. Notable were a further deterioration of Greek spreads – at just over 8% this morning, and a small increase in French and Italian spreads after a volatile trading day. The euro/dollar rate has stabilised at around $1.28 for now. The rise in Greek spreads has to be seen in the context of a very thin market. This is not a generalised bond market rout by any stretch. To alleviate the situation in Greece, the ECB yesterday confirmed a Reuters story that it would from now on apply a smaller discount for collateral from Greek banks for the regular refinancing operations. Reuters writes that Greek banks had reduced their borrowing from the ECB by €2bn to €42.6bn last month. A Greek official is quoted as saying that the new smaller discount meant an extra €12bn could be tapped by Greek banks. Of the market data that worries us the most is the decline in recorded inflation expectations. The inflation forward swaps are now 0.98% for the 2y-2y and 1.772% for the 5y5y. (Think of it as a five-year forward rate, starting five years from today. It is a measure of future expectations, minus the more immediate future.) The markets are converging to the view (one we have expressed for some time) that inflation expectations have already come unstuck in the eurozone, and there is a danger that this shift in expectations could turn into a self-fulfilling prophecy. Eurostat yesterday confirmed its September flash estimate of headline inflation at 0.3%, and core inflation at 0.8%. Eurostat’s August trade statistics show a 3% decline yoy, but trade was still up 1% yoy during the Jan-Aug period. The trade balance from €7.3bn in August 2013 to €9.2bn in August 2014. The eurozone’s strong trade surpluses is one of the factors supporting the euro/dollar exchange rate, and frustrating those who are predicting a steep fall. Another factor is a clear shift in Fed policy. Bloomberg reports that James Bullard of the Kansas Fed is proposing that the Fed should postpone the end of QE because inflation expectations are declining there as well (disinflation is one of the eurozone’s most successful exports these days). Bullard has been quite hawkish recently, so this is an important shift that may well have majority support on the Fed’s Open Market Committee. If the US were to extend QE, and if the ECB were to procrastinate on QE, we might see a reversal in the recent decline of the euro, back towards the level prevailing before the June decisions. The fall in the euro was premised on the notion of further loosening in the eurozone and tightening in the US. The markets are still, by and large, counting on QE, but if this does not happen by November or December, we would expect the overall sentiment to shift.
Posted on: Fri, 17 Oct 2014 07:51:21 +0000
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