When Yanis met Wolfgang

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European Central Bank

The Greek finance minister Yanis Varoufakis met his German counterpart Wolfgang Schaeuble this week. Although it was a frosty meeting, we think that a new deal for Greece is actually becoming more reachable. Before that, the big concern is the liquidity of the Greek government and the country’s banks. Meanwhile, a whole range of economic data suggest that economic prospects for the eurozone are brightening. We have revised our forecasts for GDP growth upwards and are now even further above consensus. In contrast, we have revised down our forecasts for government bond yields and the euro. Finally, the strong US labour market report keeps the Fed on track to raise interest rates around the middle of the year.

Despite this uncomfortable meeting, a deal has recently become more feasible. Nick Kounis Nick Kounis Head of Macro Research

Probably not the beginning of a beautiful friendship

On the surface, the meeting between the Greek finance minister Yanis Varoufakis and his German counterpart Wolfgang Schaeuble was far from a big success. Mr. Schaeuble said afterwards that the two of them ‘agreed to disagree’. However, Mr. Varoufakis did not even agree with that, saying ‘we didn’t even agree to disagree’. So it was not exactly ‘love at first sight’.

A deal looks to more reachable

Despite this uncomfortable meeting, a deal has recently become more feasible. Greece previously rejected the idea of a Euro-IMF adjustment programme. Yet at the press conference, the Greek finance minister said that the country was looking a ‘bridging programme’ to tide it through until a new deal was struck. He also said he agreed with 70% of what was in the old programme. This suggests there is even more negotiating room than previously.

The three elements of a new agreement

We think a new deal will have three pillars. First, a new reform programme, with more emphasis on tackling tax evasion and vested interests, and less on welfare and social spending cuts. Although the previous government implemented many reforms, these were areas it tackled rather half-heartedly.

Second, debt relief for Greece, perhaps in steps, conditional on reform progress. Help on this front was already promised to Greece in November 2012 by the Eurogroup. Greece’s debt burden does not look sustainable under reasonable assumptions.

Third, a lower primary budget surplus target (fiscal balance ex. interest payments). The current target is for a surplus of 4.5% GDP in 2016-2017 and 4% beyond that, levels that are very rare historically for any country. Greece’s surplus for 2014 is estimated 1.5% GDP. A lower target would fit with the lower level of debt and allow less aggressive fiscal consolidation.

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Liquidity key before deal is reached

A big issue in the meantime is liquidity for the Greek government. Greece does not plan to take fresh funds under the existing Euro-IMF programme. This means the government will have to finance itself up to the point a deal is reached, muted to be end May. Up to then, the government has T-bills maturing of EUR 9.5bn.

ECB pushes Greek banks to ELA

Liquidity for the Greek banks – which will help finance the government by buying T-bills – is also a question mark. The ECB decided earlier this week to no longer accept Greek government bonds as collateral in its refi operations. This means that Greek banks will turn to Emergency Lending Assistance (ELA), which is liquidity provided by the Greek central bank, at its own risk.

Reports suggest a EUR 60bn limit

German media reports suggest that the ELA limit will be EUR 60bn, which would allow the Greek banks some breathing space in the near term. They currently borrow EUR 56bn in normal refis. The banks have assets apart from Greek government bonds, which would allow them to borrow an extra EUR 20bn in regular operations (so EUR 80bn total borrowing). They need the space given that there is significant deposit withdrawal underway, while they will also may be pressured to finance the government. However, the situation is clearly fragile and cannot go on in this manner for a long period.

Governing Council can block, but hurdle is high

The ECB’s Governing Council can restrict ELA to the Greek banks if it judges that it interferes with the ‘objectives and tasks of the Eurosystem’. However, the Council would need a two-thirds majority to block ELA. In addition, it would be a very big step as it would throw Greece’s financial system and economy into chaos, potentially increasing the risk of a euro exit. Given this, we think most Governing Council members would keep liquidity provision available until there is a clarity in terms of the political negotiations.

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We have revised our eurozone growth forecast upwards

Despite the risks in Greece, we have become more optimistic on the outlook for the eurozone economy. We have revised our GDP forecasts to reflect lower oil prices, the decline in the euro and the general easing of financial conditions brought about by the ECB’s QE programme. We now see GDP growing by 1.6% this year and 2.2% next (previously: 1.5 and 1.9% respectively).

Although the revision for the annual average for this year is only slight, this disguises a more significant revision to the quarterly profile. If we are right the relatively downbeat consensus will be surprised positively.

Eurozone data point to brighter economic outlook

Reports out of the eurozone this week suggested that the economic recovery is building some momentum. Annual retail sales growth rose to 2.8% in December, the highest since March 2007. In the fourth quarter alone, retail sales were up by 0.9% qoq. Meanwhile, car registrations were up by 2.1% qoq last quarter, a sign that other areas of consumer demand are also doing well.

This is not what a deflationary spiral is meant to look like

This is why the oil-driven falls in consumer prices can be seen as ‘good deflation’. Falling prices – driven by the collapse in oil prices – are giving consumer spending a lift. This appears to contradict worries about a deflationary spiral, which would be characterised by falling prices leading to consumers cutting back spending.

Labour market improving, German industry on the up

The fall in oil prices should be seen as a tax cut and a rather big one at that. It will provide support to consumer spending for a number of months, but then the effects will fade. For a sustained recovery, the labour market needs to improve. Fortunately, there are signs this is happening. The composite jobs PMI rose to 51 in January from 50.8 in December, the highest since July and before that September 2011. Job growth is still slow, but is heading in the right direction.

To top off the good news, German factory orders jumped in December. This is a volatile series, but both orders and output accelerated for Q4 as a whole. Capital goods orders led the way, suggesting that investment should also firm going forward.

US labour continues going strong

The US economy has been performing strongly over recent quarters and this is very visible in the labour market. Nonfarm payrolls rose by 257K in January after an upwardly revised 329K jump in December. The 3-month average for job growth is at its highest since 1997! Disappearing labour market slack is starting to push up wage growth. Average hourly earnings accelerated to 2.2% yoy in January from 1.9% in December.

Fed on track to raise interest rates this year

The labour market report confirms that the Fed is on track to raise interest rates in the coming months. We think that the move will likely be in June of this year. A lot now hangs on core inflation, which was weak in December. A January rebound (data are out later this month) would confirm that the Fed will start to normalise its policy rates in the Summer.

Government bond yields revised lower

We have made revisions to our interest rate and currency forecasts. Given the upward revisions in our eurozone economic growth forecasts, it is perhaps surprising that our revisions for bond yields are going in the opposite direction. We now expect 10y Bund yields to end the year close to current levels at 0.4%, rather than 1% previously. However, we think that on 3-month horizon, the yield will fall further, to reach just 10bp.

Acute scarcity due to ECB and weak supply

The ECB’s large scale government bond purchases, in combination with low net supply of core bonds, will create a situation of acute scarcity (our Euro Sovereign Playbook 2015: ‘Acute scarcity of AAA bonds’ published today contains more on this subject). This situation will also continue to dampen US 10y Treasury yields, which will look increasingly attractive. Our end of year forecast is now 2.1%, down from 2.7% previously, implying a more modest rise, even given Fed rate hikes.

EUR/USD set to fall further

We also expect the EUR/USD to fall even further. We see it at 1.05 at year-end and 0.95 at the end of next year (previously: 1.10 and 1.00 respectively). A gradual rise in Fed policy rates this year will contrast sharply to aggressive ECB balance sheet expansion. The lessons from the US experience, is that the currency falls during QE as well as in anticipation of the programme.

Global monetary easing cycle continues

The US aside, most major central banks around the world remain in full monetary easing mode. The Reserve Bank of Australia cut its cash rate target to 2.25% from 2.5%. The correction in commodity prices over the last few months is still hurting the economy, and the central bank is taking steps to underpin the non-mining sectors.

The People’s Bank of China to cut its reserve requirement ratio (RRR) for the country’s commercial banks by 50bp. This further loosening in liquidity conditions reflects that the authorities continue to take modest easing steps to keep the economy on the path of a soft landing. We expect further easing going forward in the shape of interest rate cuts. Our base scenario is that China’s economy slows to 7% this year, compared to 7.4% last year.

Easier monetary policy around the world, ongoing strong US demand and lower oil prices are good reasons to expect firmer global growth in the months ahead.

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