Eurozone bond yields are now so low they suggest a recession is imminent, though the European Central Bank’s dramatic action in September along with other more positive macroeconomic factors make that unlikely. Rates were cut again after the Eurozone recovery came to a halt in the second quarter. GDP growth amounted to exactly 0.0% compared to the previous quarter, while gross fixed capital formation dropped 0.3%. The German economy shrank, somewhat surprisingly underperforming France, and the third-largest economy, Italy, fell back into recession. The economic impact of the Ukraine crisis 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: German 10-year yields are currently below 1.0%, and Italian yields are currently 2.3%. For the privilege of lending up to three years’ money to governments such as Germany, investors now pay a premium. The continuing relentless bull run on bond markets was the striking development this August. 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. Léon Cornelissen, Robeco's Chief Economist, considers the likelihood of a new European recession to be small. Robeco expects 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.
Ukraine crisis ending in a frozen conflict?
Evidence is mounting that the German economy is being hit by the ongoing jitters over the Ukraine crisis. German businesses are very cautious about making new investments. Gross fixed capital formation declined 2.3% in the second quarter. But the Ukrainian crisis 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. On the other hand it has demonstrated a cautious attitude because the change in the military balance has not resulted in an offensive to take cities such as Odessa or Kiev. The logic of the situation suggests a stalemate, a so called ‘frozen conflict’. The Eastern Ukrainian provinces including a land bridge to recently 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 economic impact. Under these circumstances business confidence in Europe could rebound.
Of course, the current de-escalation in Ukraine could in the end turn out to be a “judo-inspired trick” by Russian President Vladimir Putin, who has a black belt in the sport. During the winter, when Europe is much more vulnerable to an immediate cut-off of Russian gas, tensions could rise again, though it should be kept in mind that countries such as Germany are already in a position to withstand a five-month boycott. The ultimate aims of the Russian leadership remain unclear. It could easily decide to stir up ethnic tensions in the Baltic region. Possibly we have only seen a couple of moves in what could turn out to be a very long chess game. We cannot be sure. But for the time being, our baseline scenario is a de-escalation of the conflict.
Shale gas revolution helps world economy
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. 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
The ECB played its part by marginally lowering interest rates to 0.05% and announcing a buying program of Asset Back Securities (ABS), suggesting a possible size of one trillion euros. As the current European ABS market is not well developed, this potential size looks ambitious. 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. Very strong confidence indicators in the US (an ISM manufacturing reading of 59, non-manufacturing 59.6) benefit the US dollar as well. 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 will help keep down the euro and long-term interest rates.
Macro outlook: Fiscal policy is no longer restrictive
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. Automatic stabilizers in the Eurozone will as a consequence probably get more room to maneuver in the coming months and governments within the Eurozone will start to make a more positive contribution to economic growth.
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, confirms Robeco’s Chief Economist. 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%. But as the US economy will continue 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 Robeco sees little value in European and US government bonds at current yields.