Pioneer Investments’ Tanguy Le Saout pensive ahead of first US interest rate rises

Tanguy Le Saout, head of European Fixed Income at Pioneer Investments, has looked at evidence of European economic growth and its impact on ECB interest rates.

What brought renewed investor confidence in the Eurozone’s economy?

Gross Domestic Product (GDP) increased in the second quarter after six straight declines. Data was on the optimistic side of expectations, but investors appear to become more confident before their release thanks to encouraging evidence from supposedly reliable forward-looking indicators. Some business surveys gained in popularity for correctly predicting GDP growth data, which tend to be backward-looking and, more importantly, are prone to frequent revisions over time. Business surveys, once the information is collected, cannot be challenged by future revisions.

What is the message of business surveys?

The global Purchasing Managers Index (“PMI”) rose above 50 this summer, indicating that a majority of the companies surveyed expanded their activity for the first time in two years. The euro side of the index has lagged the global average throughout the sovereign debt crisis, with only Germany as an exception. The PMI staged a slow recovery about a year ago, whereas GDP data (until recently) have been in “recession territory”, the reason why the PMI has gained a reputation for being forward-looking.

What are the main implications on euro periphery?

Another feature of the latest PMI is that the euro periphery has also regained ground. Other surveys, such as those conducted by the European Commission, have shown a similar pattern and we might see GDP growth in peripheral countries converging on Germany’s, if this evidence is further confirmed.
Exports to China and other Emerging countries used to make the German economy the best performer in the eurozone, but Emerging economies are not the driving force they used to be for global growth.

Is the response of the financial markets consistent with this new scenario?

Sovereign credit spreads stayed at two-year lows, but rising German yields accounted for most of the market reaction. Core bond yields have actually been the most involved, as 10-year German government yields rose almost half-a-point in less than one month. They are catching up with US Treasury yields, as the policy normalization plans such as the Federal Reserve’s “tapering” of QE were also seen likely in Europe. It may be premature to match the US and Europe, but unexpected turns of events have often prompted this kind of reaction in the financial markets.

Do you expect the recovery to affect ECB guidance on low rates?

The latest board of the European Central Bank (ECB) left benchmark rates unchanged without incurring criticism from the financial markets which, until recently, expected it to take further action to overcome the recession. However, the ECB chairman pointedly said that there are ongoing downside risks to the economic growth and that inflation should remain subdued as a result.
Indeed, we should not get carried away by the latest encouraging evidence. The second-quarter GDP gain is welcome, but has only partly offset the losses induced by the recession. This is a notable difference with the US economy, where the GDP has surpassed the pre-recession peak. A recent report by the German Central Bank called on the ECB to raise rates, if inflation pressures rose, and that may be the reason why the “forward guidance” on low rates appeared to be more forcefully affirmed by the September ECB board.

How could you figure out that the ECB is following the Fed footsteps instead?

We are tracking any evidence of course, notably the forward interest rates in the overnight market (EONIA). The EONIA spot rate is still near zero, but the forward contracts are pointing to slightly higher rates going into next year. Admittedly, such an increase would be barely noticeable over the last 3 years, but it is somewhat visible year-to-date.

Another supposed sign of normalization has come from the declining ECB balance sheets, due to early repayments of long-term special loans (released under the LTRO program) from a few banks. The declining amount of outstanding LTRO loans may be evidence of a slow but steady improvement in banks’ financial health. A large majority of Euro banks bid for cheap LTRO funds in the midst of the sovereign crisis, but some were not (strictly speaking) in a liquidity crunch and could afford to pay back those loans well in advance. However, such early redemptions have sharply increased year-to-date. The overall sector may take longer before a full recovery, as shown by weak data on loans to businesses and households, but efforts to strengthen the capital buffers are a very good start.

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