Today’s calendar does not include any notable data releases, so I will discuss several developments that could lead to important turning points in asset prices.
The highlight of next week will probably be the latest Japanese data and the release of the German Ifo Business Climate Indices. After the weak Markit purchasing manager readings - yet upbeat ZEW sentiment - a confirmation that Germany’s outlook has deteriorated would be nice. It could increase the chances that Germany would allow the European Central Bank (ECB) to proceed with more aggressive monetary policy or the European Commission to ignore the budget deficits of Italy and France, which are way above what has previously been agreed in writing. Next week's trading will be disrupted by Thanksgiving in the US at the end of the month, and the slow winter season has seemingly already started in the markets as well.
Mario Draghi speaks (08:00 GMT)
The ECB’s president Mario Draghi will be speaking today at the 24th European Banking Congress. This invitation-only event gathers a heavy audience and the list of speakers is impressive: Germany’s minister of finance Wolfgang Schäuble, Bundesbank president Jens Weidmann and the heads of Deutsche Bank, Commerzbank, the Single Supervisory Mechanism and Bruegel. Two topics to be discussed are “More Europe, Better Europe?” and “Banking Union and Regulatory Reforms: Mission Accomplished?”.
Today’s speech by Draghi is titled “Reshaping Europe”, and he will almost surely mention the downside risks and the low inflation, and how combating deflation is the utmost policy priority for the ECB at the moment.
Could it all come apart? Junahi Huopainen's outrageous prediction for 2015 is the beginning of the end for the euro area. Photo: Thinkstock
Draghi’s address to the European Parliament earlier this week was dovish – he reiterated that the ECB would consider purchasing sovereign bonds. The ECB’s Yves Mersch earlier stated that the ECB would consider all kinds of assets, not only the sovereign bonds. He mentioned exchange-traded funds, gold, real estate and shares as theoretical options.
As the ECB’s already-announced policy measures will not be enough to increase the size of the ECB’s balance sheet to the desired level (2012 highs imply an increase of over one trillion from current levels), the ECB is widely seen to eventually also purchase sovereign bonds. The size and depth of other asset classes are simply too small for the ECB’s total purchasing needs.
The ECB’s next policy-setting meeting will be on December 4, 2014, but unfortunately, the date for the second allotment of TLTRO-funds will be allotted on December 11, meaning that there is a chance that the central bank will wait and see whether banks will show interest in the TLTRO-funds. Seeing the results would make sense, as if the results are unsatisfactory, it would be easier to convince Germany’s central bank that more drastic policies will be needed.
While dovish comments should at the moment be negative for the EUR, the market might be a bit reluctant to react to mere reassurances. Further EUR weakness would require a firm statement that ECB will do “whatever it takes” to reach its balance sheet goal. The expectations are high – Bloomberg’s monthly survey of economists found that a clear majority sees the ECB beginning its balance sheet increases in early 2015 and continuing them into 2016. The majority also thinks that the ECB will successfully meet its predefined goals. A direct quote from the Bloomberg’s article, a must-read:
“More than three-quarters of economists said that if the ECB does enlarge the program, it will buy corporate bonds; 43 percent said it will buy the debt of government agencies; and 57 percent predicted it will buy sovereign bonds. More than a fifth said it will add stimulus by making the targeted bank loans more attractive.”
The markets would not take kindly any setbacks with so high expectations, so I am bracing myself for a correction higher in the EURUSD.
The US-German bond yield spread
Take a look at this graph. It shows the US and German ten-year bond yields, and the difference of the two:
For the past decades, the two yields have both been trending lower hand-in-hand, and the spread between the two has oscillated between -1.51 percent and a high of 1.61 percent. I recently had a word with a bank strategist who thought that there was further upside left in the spread, as US rates would conceivably move higher as the recovery there continues and the Fed prepared to raise rates. At the same time, Europe’s interest rate hikes are in the far future.
I noticed that the spread is now at historically high levels, and as the growing divergence between the US and euro area is already the consensus view, there is a chance of a surprise move to the opposite direction, if only for the purpose of reverting to the mean. It could be that the Federal Reserve’s rate hikes are postponed, or that the bond yields in Europe will move higher if it becomes apparent that the ECB a) will not purchase government bonds or b) the ECB purchases them and the inflation outlook begins to improve. Either scenario could lift European yields!
But then another, and perhaps more important story hit me. Look at the timing of the lows and highs of the spread:
Lows
1992: The bottom of the post-eighties recession and the break-up of the European Exchange Rate Mechanism
2003: The bottom after the Internet bubble burst.
2009: Financial crisis in US about to end, stock market bottom
Highs
1999: Just before the IT bubble burst
2007: Just before the financial crisis
…and now we are at the same levels as the previous highs. If this plays out as it has previously, the 2015 or 2016 could be a very rough year for risk assets like stocks and high-yield bonds.
2015 euro area breakup?
In 2005, I participated in an online discussion on the timing of a euro area’s possible breakup. I wrote that there were “recessionary tendencies everywhere” and that it would take a long time for the dismantling to happen, with “Club Med-countries” first to take a hit from the credit markets, and then the crisis would eventually spread to the core countries. I said that my gut feeling is five years, but a more sober estimate would have been ten years. Given the date of the discussion, July 2015 would be the time.
Regarding the timing of financial crisis, while discussing the Mexican crisis, professor Rudi Dornbusch said it well:
"An overvalued currency isn't tantamount to a crisis. The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought, and that's sort of exactly the Mexican story. It took forever and then it took a night."
I wrote a quick “outrageous prediction" on a possible path for the euro area’s breakup, read it here in the comments, and remember to write one yourself!
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