Monday 11 December 2017

The word is bonds, treasury bonds, and you should watch them carefully

An employee removes excess felt from berets inside the factory of 174-year-old beret-maker Laulhere, in Orolon-Sainte-Marie, France. Growth in France was at a standstill in the last quarter. Balint Porneczi/Bloomberg.
An employee removes excess felt from berets inside the factory of 174-year-old beret-maker Laulhere, in Orolon-Sainte-Marie, France. Growth in France was at a standstill in the last quarter. Balint Porneczi/Bloomberg.
James Saft.

James Saft

Very poor European growth figures add a hint of concern about a cyclical downturn to enliven the ongoing worries about a structural malaise.

What is particularly striking is the way in which the eurozone and the US, though operating in vastly different conditions, are both exhibiting some common traits: very poor economic growth, very low inflation and a bond market which is predicting more of the same.

The news from Europe last week was disappointing, with euro area GDP advancing only 0.2pc in the first quarter. Most of that paltry growth seems to have come from a buildup in inventories rather than an expansion in final demand.

And while Germany did surprisingly well, growing by 0.8pc in the quarter, the data elsewhere was far less good. Growth in France was at a standstill, while in Italy it contracted by 0.1pc and the Netherlands shrank by 1.4pc. Inflation in April was at 0.7pc with large swathes of the eurozone in or near outright deflation.

No surprise then that what has been a source of calm – the fact that borrowing markets are ticking over nicely for euro area sovereigns – is now looking like a warning sign. German 10-year yields are as low as 1.37pc, while even Italy can now borrow for 10 years at just over 3pc. Eurozone bonds are telling you that yes, as the European Central Bank essentially promises, you will get your money back, but don't hope for too much economic growth or inflation to go along with it.

All of this puts pressure squarely on the ECB, which at last seems ready to move, almost certainly at its June meeting. Look for a cut in all official rates, something which would take the deposit rate into negative territory. Here's hoping too the ECB gets over its institutional and procedural hurdles and manages to actually create something to channel credit to smaller businesses.

That could, according to reports, take the form of a tit-for-tat injection of liquidity, with the payback from banks taking part being an increase in lending to smaller firms, or a more straightforward QE-style programme of buying up securitised small and medium-sized entity loans.

All of this isn't so much too little too late, as same stuff, different year. Or, if you prefer, same stuff, different continent.

Compare, for example, the US to the eurozone. Couldn't be more different, I hear you say. After all the US enjoys cheap energy, no real fear of Russia there. And the dollar is cheap enough to not only make eurozone exporters jealous but to force the ECB's hand. Also, the US enjoys cheap market interest rates in a financial market-driven system.

US firms use public markets far more for financing than their eurozone counterparts, who still rely on banks. As said banks in the eurozone are in difficulties this causes, well, issues. Not to mention the US's other advantage – it is a country, not a currency union.

So with all of these advantages, you'd expect the US to be hitting it out of the park.

Well US first-quarter growth was just 0.1pc, with all of the increase attributable to an increase in healthcare spending. Take out healthcare and we'd be looking at a contraction of 1pc in the first three months. As for inflation, though there has been a bit of movement in producer prices, benchmark consumer price inflation is still below target, with core inflation 1.8pc in the year to April.

US 10-year yields touched 2.44pc and have fallen by half a percentage point so far this year. That's striking given the higher-than-expected inflation readings.

Clearly in both the US and eurozone there is some reason to hope the rest of the year will be stronger than the first six months. And yes, you can say that GDP reports are backward looking and so might be somewhat discounted as old news.

The bond market, however, is forward looking. And what the bond market is telling you on both sides of the Atlantic is that there is very little expectation for growth or inflation.

That's particularly remarkable given the role central banks are playing. On the one hand treasuries are rallying despite the Fed buying up fewer of them. Eurozone inflation and growth expectations seem to take very little comfort from the idea of a more active ECB.

Watch bonds, they just might be telling you something. They usually do.

Dan O'Brien is on leave.

Irish Independent

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