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Eurozone bond yields are now so low they they suggest a recession is imminent though the ECB’s dramatic action makes that unlikely, says Robeco’s chief economist.
Yields on benchmark German debt fell below 1% in August, partly due to the economic fallout caused by the Ukraine crisis. In the second quarter, the Eurozone recovery came to a halt, with GDP growth at zero compared to the previous quarter.
The German economy shrank, somewhat surprisingly underperforming France, and the third-largest economy, Italy, fell back into recession. The economic impact of sanctions imposed on Russia over Ukraine has been much larger than expected, primarily due to its confidence-damaging nature.
“As a consequence, bond yields have come down to amazingly low levels that suggest a Eurozone recession is imminent, though we consider the likelihood of a new recession as small,” says Léon Cornelissen. “We expect a stronger third quarter for a number of reasons and continue to expect an ongoing recovery of the Eurozone economy. The main risk to this scenario would in our opinion be a severe further escalation of the tensions between the West and Russia.”
“Aside from the weakening of the European economies, the downtrend in actual inflation and the growing fears of Japanese-style stagnation that can all explain these low yields, they are also a reflection of the likelihood of further aggressiveness by the European Central Bank. ‘Don’t fight the ECB’ could be an appropriate motto.”
The ECB sprang into action at its 4 September meeting with a surprise 10 basis point cut in all the key rates, setting the core refinancing rate at 0.05% with a bottom range that is effectively zero. The savings rate moved further into negative territory at -0.2%, which means banks would have to pay for leaving surplus cash at the ECB.
But the record low yields mean that bond prices – which move inversely to yields – have risen, making many of the more sought-after bonds expensive. “It now means that for the privilege of lending up to three years’ money to governments such as Germany, investors have to pay a premium,” says Cornelissen. “The continuing relentless bull run on bond markets was the most striking development this August.”
Ukraine crisis ending in a frozen conflict?
Evidence is certainly mounting that the once mighty German economy is being hit by the ongoing jitters over the Ukraine crisis, though it is now showing signs of becoming less heated. Russia has made it clear that it won’t allow a destruction of the pro-Russian separatist region in Eastern Ukraine by sending sufficient troops and weaponry to the rebels.
“On the other hand, Russia has demonstrated a cautious attitude because the arranged change in the military balance has not resulted in an offensive to take cities such as Odessa or Kiev,” says Cornelissen. “The logic of the situation suggests a stalemate, a so called ‘frozen conflict’. The Eastern Ukrainian provinces and annexed Crimea will remain firmly under Russian control, but hostilities will end, paving the way for what will most likely be long-winded negotiations.”
“The current, rather weak sanctions will remain in place, with limited long-term economic impact. Under these circumstances business confidence in Europe could rebound.”
Shale gas revolution helps world economy
Cornelissen warns that Eastern Europe is not the only region in which geopolitical tensions are flaring up. The Islamist insurgency in Iraq is a potential threat to oil supply, although Brent oil prices are trending down from their peak in June.
“An important factor is the shale oil revolution in the United States – it is currently acting as a ‘supplier of last resort’, a role earlier taken by Saudi Arabia,” he says. “It is highly uncertain how long the shale oil revolution will last, but the currently well-behaved oil prices are a boon for the world economy, including the Eurozone.
“The price of oil is an important factor driving down headline inflation. Core inflation in the Eurozone is still 0.9% on a yearly basis, despite all the talk about deflation.”
Accommodating monetary policy weakens the euro
Cornelissen says the ECB still has plenty of economic weapons in its armory, though he doubts whether the program it announced to buy back up to one trillion euros of Asset Back Securities (ABS) is workable.
“As the current European ABS market is not well developed, this potential size looks ambitious,” he says. “It will take time to implement the ABS program and its beneficial effects will be gradual. But in so far as the program helps to weaken the euro it immediately benefits European exporters.”
“The ECB has still one weapon of last resort – generalized QE of sovereign bonds. But this weapon will only be used if the European economy weakens materially further. This option remains clearly on the table and helps in keeping down the euro and long-term interest rates within the euro area.”
Fiscal policy is no longer restrictive
Parts of Europe still need to reform to promote a meaningful long-term recovery, Cornelissen says. During the Jackson Hole summit, ECB president Mario Draghi sketched the outline of a grand bargain, in which the ECB would do more in exchange for fiscal stimulus (in Germany) and structural reforms (in France and Italy).
“Chances of meaningful reform packages in France and Italy are low, but there is already a political agreement about a flexible interpretation of existing budgetary rules within the Stability and Growth Pact,” he says.
“Automatic stabilizers in the Eurozone will as a consequence probably get more room to maneuver in the coming months and governments within the Eurozone won’t any longer make a negative contribution to economic growth.”
Outlook for fixed income markets
Meanwhile, investors should prepare for more of the same, as remarkably low interest rates and tight sovereign spreads within the euro area will stay with us in the coming months as long as the ECB keeps its easing bias, the chief economist predicts.
“The search for yield implies that the Eurozone is currently exporting low interest rates to the US, where 10-year bonds offer a yield of about 2.5%,” he says. “But as the US economy continues to strengthen, talk about the timing of the first interest rate hike will get louder, and gravity could be reversed: US long-term interest rates may push up those in Europe.”
“A necessary condition would be a resumption of the European recovery, which partly depends on geopolitical developments. Our baseline scenario is a stronger Q3 GDP which will diminish pessimism about the European recovery. As a consequence we see little value in European and US government bonds at current yields.”