A number of big macro themes continued to be in focus last week. The sharp sell-off in the government bond market, the risk of a Greek exit from the eurozone, the chance of a UK exit from the EU, better eurozone growth data and ongoing disappointments out of the US economy. We look at each of these issues in turn and assess the outlook and implications.
The continuation of QE should see core bond yields falling back over the next few months
Nick Kounis Head of Macro Research
Will the bond rout continue?
No – at least not in the next few months. It is true that government bond yields, especially in the core of the eurozone, are still far away from fundamentals. However, this reflects QE and it seems to us that ECB asset purchases are set to continue in the coming months. Indeed, ECB President Mario Draghi made this clear in a speech last week. He said that the ECB would implement the QE programme ‘in full’ meaning at least until September 2016. In addition he judged that ‘quite some time is needed before we can declare success, and our monetary policy stimulus will stay in place as long as needed for its objective to be fully achieved on a truly sustained basis’. We think Mr Draghi will stick to this message at the press conference following the June Governing Council meeting.
The continuation of QE should see core bond yields falling back over the next few months. Against the background of weak supply and aggressive ECB purchases, we think that we will see a scarcity of AAA government bonds that will keep bond prices inflated compared to fundamentals. Indeed, one of the reasons yields have risen over the last few weeks is that there has been some new supply by eurozone governments over this period as they front-load their funding before the Summer. However, this will dry up going further forward, while ECB buys will continue.
Overall, we think that the bond market sell-off does not represent the start of the big bond market correction but rather a false start. Having said that an eventual large adjustment is just a matter of time. We think that this will take place early next year when the end of QE or the QExit really comes into view. It seems unlikely to us that the ECB will continue QE beyond September of next year, and tapering could even come earlier in that year as growth and inflation rise.
Given these views and recent market developments, we have raised our German 10y government bond yield forecast for this year by 20bp (to 0.3% at 3-months and 0.5% at year end). But we stick to our forecasts for 2016 (1.4% by year end).
Is Greece any closer to a deal?
Only slightly. Following the meeting of eurozone finance ministers, the statement had a somewhat more positive tone. The Eurogroup “ welcomed the progress that has been achieved so far”, while acknowledging that “the reorganization and streamlining of working procedures has made an acceleration possible, and has contributed to a more substantial discussion”. However, “ more time and effort are needed to bridge the gaps on the remaining open issues” . Eurogroup head Dijsselbloem added that the negotiations were “more efficient, more positive, more constructive”, while “faster progress” was being made.
Our base case remains that Greece and the EU will reach an agreement, probably at the last possible moment. The Greek government appears to be running out of cash. According to finance minister Varoufakis the liquidity issue had become “terribly urgent”, referring to a time period of “the next couple of weeks”. The official deadline of the current bailout extension is the end of June, but we have serious doubts about whether the country could wait that long for financial aid. Several payments to the IMF are due in June (total around EUR 1.5bn). So we think around the end of this month the pressure to reach an agreement will really become acute.
Will the UK leave the EU?
No, but the risk is not negligible. With the Conservatives winning the elections and returning to government with a small majority, the Brexit issue has come into the limelight. Prime Minister David Cameron has promised to hold a referendum on UK membership of the EU by 2017 at the latest. Before that, he intends to renegotiate the UK’s relationship with the EU with other countries. If there is a successful renegotiation Mr Cameron would support ongoing membership in such a referendum.
It is likely that the UK will vote to stay in the EU in our view. Opinion polls suggest that there is a majority in favour of membership (although as the election showed – they can be wrong). Furthermore, we think it is likely that the Prime Minister will achieve the changes he is looking for, as it looks like his ambitions in this regard are quite modest. Much of the political establishment and business are likely to support the ‘in’ camp.
UK exit from the EU would likely a be a negative for the UK economy as it would lose free access to the biggest single market in the global economy. This would be bad for UK exporters as well as foreign direct investment into the country with of view to accessing the EU. The uncertainty surrounding the negotiations and referendum would likely weigh on UK assets.
Is the eurozone economic recovery for real?
Yes. GDP growth firmed to 0.4% in Q1 from 0.3% in Q4, which may not be spectacular, but shows a gradual recovery is underway. In addition, there are reasons to think that the economy will pick up some pace in the coming quarters. First of all , the drop in oil prices is providing a windfall to consumers of 1-1.5% GDP. Second, financial conditions have eased with bank loans becoming more available as well as cheaper. Indeed, the ECB surveys suggest that SMEs – the lifeblood of the economy – are now experiencing easier access to finance. Finally, the fall in the euro will support exports. Over time, these initial triggers will ease but it the hope is that by then companies will be stepping up hiring, investment and stockbuilding, leading to a virtuous circle of growth.
Is the US recovery coming off the rails?
No – but the data is starting to test our patience. After the terrible first quarter, the improvement in economic data has been disappointing. Indeed, retail sales, consumer sentiment and industrial production all disappointed last week. The strong dollar and falling investment in the oil and gas sector are certainly negative for the industry. However, the large domestic economy should benefit from a stronger labour market, lower oil prices and a pickup in the housing market. Meanwhile, household and corporate balance sheets look strong and financial conditions remain accommodative. Stronger growth remains the most likely trend growing forward. However, economic reports need to turn soon for us to maintain our conviction.