Friday 21 June 2019

Low bond yields tell us that a slump is coming

SATURDAY INSIGHT

On the run: Unimpressive jobs numbers in the US may convince the Federal Reserve to start cutting rates sooner rather than later. Photo: Bloomberg
On the run: Unimpressive jobs numbers in the US may convince the Federal Reserve to start cutting rates sooner rather than later. Photo: Bloomberg

David Chance

MOST economic commentators took comfort from ECB signals on Thursday that it stood ready to step in if the economy worsened. However, the bond market told a different story, one in which growth and inflation are set to dip even lower.

Yields on 10-year bonds from Germany, the Netherlands, Spain, Portugal, Ireland and Cyprus have hit record lows on Thursday and Friday.

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Data on Friday suggested that the bond market was right as industrial production in Germany, the economic powerhouse of Europe, registered a whopping 1.9pc drop in April from March, suggesting that a recovery in the first quarter of this year was transitory.

That news was followed by the mighty Bundesbank, which weighed in with a large cut to its forecast for Germany's growth to 0.6pc this year, down from a 1.6pc forecast made in December, blaming the country's poor export performance for the downward revision.

"Looking at financial markets from the helicopter, it seems evident to us that a disinflationary shock has hit the global economy, resulting in a sharp bond market rally and a slump in commodity prices," investment bank Danske said on Friday.

The first problem for the eurozone is that it is more exposed to trade than, say, the United States - and President Donald Trump showed that he is once again prepared to launch tariffs on more than one front when he threatened Mexico at the same time as ramping up duties on China.

Europe could be next in line as Trump has the threat of auto tariffs hanging over the bloc - a move that would hit Germany badly, but would also hurt Ireland whose dependence on goods exports to the United States is larger than any other EU state, relative to the size of the economy.

The second problem for the eurozone is that economic growth is sluggish. Even if the US economy slows, it will do so from a much higher base than the single currency bloc which recorded annualised growth of 1.2pc in the first quarter of the year versus the 3.2pc figure recorded in America.

While the direct economic impacts of the trade wars are relatively small, they feed through to the economy through tighter financial conditions and weaker business confidence.

These concerns prompted Nick Kounis, head of financial markets research at ABN AMRO, to reduce his eurozone growth forecast to just 0.7pc this year, which he said "implies quarterly economic growth close to stagnation this year".

Core inflation, he forecasts, will be stuck at 1pc this year and next.

That analysis points to one direction for bond yields, down, and Mr Kounis expects the yield on 10-year German bunds to move even further into negative territory at minus 0.35pc by the end of the year.

Indicators are also flashing red in the US and Thursday marked the 10th consecutive day in which yields on 10-yeart Treasuries were below that of 3-month bills, which signals that investors expect interest rates to fall going forwards, usually a product of Federal Reserve rate cuts coming as the economy starts to stutter.

Non-farm payroll employment data released on Friday confirmed that slowing trend as they rose by just 73,000 in May, well below expectations of 175,000 jobs, and the March and April gains were revised down. "Today's report is consistent with the growing sentiment among markets and economists that the US economy is slowing down," said Gad Levanon, chief economist, North America at the Conference Board.

Those numbers may stiffen the resolve of the Federal Reserve to start cutting rates sooner.

At least the Fed has built itself some room to cut. Having reacted much more quickly to the financial crisis, it was able to start raising interest rates in 2015, while the ECB is still stuck at zero.

The poor outlook for the eurozone is compounded by the ticking time bomb that is Italy's debt.

The European Commission this week wrote to the Italian government warning it against attempts to expand its budget.

It could revive budget disciplinary procedures against Italy if it does not undertake cuts to spending and tax rises to cap the deficit.

Austerity is unlikely to achieve much in a country where debt stands at 132pc of gross domestic product, according to consultancy Capital Economics, which noted that Greece's debt was "only" 103pc of GDP in 2007.

The strictures of euro membership themselves exacerbate the problems of the bloc's third-largest economy as real interest rates and the exchange rate are set too high for Italy.

"Given the chaos that Greece has caused in the past, it is very plausible that an Italian crisis could spark an existential crisis for the eurozone," according to Capital Economics.

Irish Independent

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