By Michael Burke, B&M Research
Market expectations have shifted abruptly in the direction of European Central Bank (ECB) tightening. In the early part of May, the July three-month Euribor contract had fallen by 25bps, implying that rates will rise towards 3.75% over that period, although soothing words from ECB President Wim Duisenberg have since sparked a recovery. The peak compares to an official two-week repo rate of 3.25% and a three-month repo rate of 3.57%. At its height, the premium over these two official rates implies that a 25bps rate hike is a virtual certainty (and the December contract implied that rates will rise by at least 75bps before year-end).
Negative comments from ECB board members, an upward revision of Euroland CPI and a series of pay strikes in Germany had all contributed to the new mood on rates. Now the market has turned 45 degrees, but not 180 degrees in its is rate expectations, even though it has been a practise of the ECB to deliberately wrong-foot the market. In this article, we examine the economic case for higher rates, the outlook for ECB tightening and market consequences of ECB rates policy.
Many commentators have also suggested that the revival of the European economy is also a factor in prompting higher rates.
However, it seems clear that the Euroland economy is neither relatively nor absolutely strong enough to warrant higher rates. Industrial production is still contracting year-on-year (despite recent monthly rises) and the growth in retail sales remains modest.
In neither case does the current rate of expansion seem to pose an inflationary risk. On a comparative basis, it is also difficult to see how these very modest levels of activity justify higher rates. In the table below we show a snapshot of some key economic variables, Euroland versus the US. In all cases, the most recently monthly data available is used. Except where stated, the data given is year-on-year growth rates.
Key Economic Variables Compared, Euroland vs US
Retail sales +4.0 1.3
Industrial production -2.0 -2.5
Unemployment rate* 6.0 8.4
Auto sales +2.3 -1.7
Labour costs 2.9 3.0
Capacity utilisation* 75.5 80.8
Construction 0.6 -0.6
Exports 0.6 -14.2
Source: B&M Research, data supplied by national authorities
*Level, not % change
In nearly all cases currently, the US economy is exhibiting a greater degree of strength than the Euroland economy, especially in the key measures of demand and output. It is also the case that unemployment is higher in Euroland, and, as far as inflation is concerned, there is no difference in the growth rate of labour costs. There is also a very large negative gap in the growth rate of exports, which may be significant for the currencies going forward.
In only one area is the Euroland economy exhibiting any major advantage over that of the US; capacity utilisation. However, the rate of capacity utilisation in the Euroland economy has been falling for five consecutive quarters, which stands in contrast to the US utilisation rates, which have been rising over the last four months. Both this decline in the capacity utilisation rates, and its absolute level do not indicate any build-up of inflationary pressures. (The Bundesbank used to regard a sub-80% level of capacity utilisation for the German economy as recessionary).
In general, US and EU capacity utilisation move together, implying that the two central banks have generally pursued a similar policy in relation to growth of output and setting their interest rates. This is also true if we consider their respective real interest rates and their levels of capacity utilisation. But on this comparison, the short-term interest rate gap between the two economies should now be just 1%, not the actual gap of 1.75% currently. That is, if the ECB were as accommodative as the Fed, the ECB repo rate should be 2.75%, not 3.25%.
In terms of European real interest rates (nominal rates minus the current level of CPI inflation) the low-point in the current cycle was at 1.2% in January. Real short-term rates are now 1.7%. This compares to a low-point of 0.6% in 1997, when the downturn was less severe. The gap between the current level of real rates is higher than that indicated by the usual relationship with EU industrial production (right axis), by around 0.7%.
However, despite all of this and noting Mr Duisenberg’s penchant for wrong-footing the markets, there is some risk that the next move on rates will be higher.
The ECB index follows on from the Bundesbank index which was a reliable lead indicator for policy. The main difficulty is in assessing whether the ECB is a policy clone of the Bundesbank, or whether it has some additional factors which determine policy. For now, it appears as if the former is the case, which would result in higher rates in the period ahead.
However, another key variable in the index is the level of the currency. The euro has performed strongly in recent weeks, partly in response to rising expectations of rate rises. If sustained, this would tend to mitigate against actual rate rises, given the damping effect on inflation.
This is the only significant factor currently which stands in the way of ECB tightening, given its (imputed) policy framework. Of course, it follows from the economic analysis above that there ought to be a whole series of economic fundamental factors standing in the way of tightening. But, the suspicion is that the ECB disregards these, and is locked into its inherited policy framework (while paying lip service to the ‘twin pillars’ of money supply and inflation).
It is far from certain that the ECB will have the confidence to suppose that the euro’s autonomous recovery has begun. They may too feel tempted to “help it along” by tightening rates ahead of the Fed.
In our judgement, this would be a huge error, both in terms of the health of the economy and from the narrower perspective of the likely trajectory of the euro.
We have previously discussed the impact of relative yield curves on the exchange rates, and shown how the relative real yield curve gap between the US and Germany (measured on the 10yr minus 1yr curve and adjusted for US and Germany inflation respectively) holds a strong relationship with the level of the exchange rate.
Given the economic backdrop, it seems highly unlikely that the euro yield curve would become steeper with higher rates. In the much more likely event that the curve flattens, this would be an adjustment back in favour of the US dollar. It is not certain that the ECB will raise rates near term. The best hope that rates would keep closer to appropriate levels is a sustained rise by the euro. But that is uncertain. The risk of tightening is on the rise, once more damaging both growth and the currency.