eurozone may 2011: focus on slowing growth ahead not lagging inflation
TRANSCRIPT
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Kaleidic
Associates Laeeth Isharc
Partner
Enquiries – Rosie Lomas
www.kaleidicassociates.com
Kaleidic Associates Thoughts on the Market – 30th May 2011
Focus on slowing growth ahead, not lagging inflation
Summary
Inflation outlook: short term peak; secular uptrend. Rise in implied breakevens reflects
commodity market rally – positioning and sentiment very extended. Just a stabilization
in commodity prices will be enough to bring down headline inflation via base effects, and
in fact we could see very significant declines in industrial commodity prices.
Forward-looking indicators: Belgian business confidence a useful barometer and shows
deterioration in outlook consistent with US data and other forward-looking Eurozone
indicators. ZEW expectations suggest focus on lagging German exports is misplaced and
we have a sharp slowdown ahead.
ECB Policy: hawkish rhetoric leads many to focus on possibility of ECB hiking more
aggressively than forwards, but historically ECB open-mouth policy has often been a very
bad guide to their actual decisions. Some similarities to July 2008. Should rates be at
zero?
Flight to quality risks: rate hikes in EONIA curve can get pushed out, but possibility of
Greek default leading to financial market disruption in Spain and Italy could lead to
market pricing an EMU breakup, with German short-end becoming the ultimate safe
haven.
Relative Valuation: leading indicators suggest growth is slowing much more quickly in
Europe than in the US, and given worse sentiment for Europe this should favour Bunds
over UST.
Market view: buy dips in the schatz and bobl outright and against US fixed income. Also
consider German steepeners 2s10s.
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Rise in breakeven
inflation correlated to
rise in commodity prices
Headline inflation to
peak shortly in Europe,
coming down for the rest
of the year
Inflation Outlook
In my notes over the past weeks, I have been emphasizing the need for caution in assessing the
outlook for inflation in the Eurozone. Although it is understandable that many commentators
were shocked by the high prints in headline inflation that we have seen since the climax of
deflationary concerns last autumn, there is no real sign of a wage-price spiral that would lead to
expectations and behaviour becoming unanchored. For example, despite recent wage increases
in Germany – a country with one of the stronger labour markets in the Eurozone - productivity
growth means that the growth in German unit labour costs remains subdued.
I first showed the chart below some weeks ago, pointing out that the rise in inflation
expectations as measured by the inflation breakeven market (blue line) was very correlated to
the rise in commodity prices (below orange line shows US wholesale gasoline price futures,
which were recently up 50% from the August lows). I said that even a stabilization in commodity
prices should over time lead to headline inflation converging towards core, and that given very
extended sentiment and positioning (crude oil bullishness peaked at a very extreme 97%
bullishness amongst small traders recently, and CFTC data shows unprecedented long
speculative positioning in the energy complex) there was a risk of further declines, possibly very
significant declines over time. I agree with the JP Morgan economists, who expect inflation to
peak shortly in Europe and to come down for the rest of the year.
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Belgian business
confidence a useful
barometer and shows
deterioration in outlook
consistent with US data
and other forward-
looking Eurozone
indicators
Clearly it is too soon to declare victory, but it is interesting that we now start to see inflation for
core Eurozone members surprise to the downside (German number last week was significantly
lower than expectations – as the chart below shows). Should there be more surprises in this
direction, focus of the market could shift quickly to the deteriorating growth outlook.
The Growth Outlook – Belgian Business Confidence
As a very open economy, Belgian business confidence has often been a useful barometer to
detect early shifts in the direction of the outlook for business activity in the Eurozone. Last
week’s number showed a significant deterioration that is consistent with the picture we see in
US data and other indicators of Eurozone prospects.
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ZEW suggest focus on
lagging German exports is
misplaced, and we have a
sharp slowdown ahead.
German Exports YoY vs ZEW Future Growth Expectations
Although Germany has experienced a stunning recovery in exports, leading indicators suggest
that we can expect a significant slowing soon. The chart above shows German exports year on
year vs the ZEW index of Future Growth Expectations advanced by one year. Beyond the global
manufacturing slowdown that street economists have been discussing for some time (driven by
the inventory cycle as well as the production disruptions from Japan), one should remember that
a very significant proportion of German exports go to peripheral Europe and it is evident that we
are seeing the effects of the growing stress here reflected in demand.
The JP Morgan Global Data Watch this week has the following to say regarding Europe
“Downside risk to EMU growth
Bucking the global trend, Euro area GDP accelerated strongly into 1Q, driven by broad-based gains outside the periphery, led by Germany. However, the region is likely now slowing alongside the rest of the world. The region has a lot to absorb: a fiscal tightening, a terms of trade shock, supply-chain disruptions from Japan, and the broader global industrial deceleration. For now, we remain comfortable with our projection that growth will continue at an above-trend pace, but the risks are to the downside. This impression was reinforced by the sharp decline in the areawide composite PMI in May. Although the level of the PMI remains elevated relative to our current growth projections, the steepness of the decline, especially in the manufacturing sector, raises some concern. As for Germany, capital goods orders declined sharply in March while shipments have been trending down since the turn of the year.”
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ECB Policy
Market participants have been focused on the hawkish ECB rhetoric of late with a focus by many
market participants, including some of our clients, on the risks of hiking more aggressively than
the forwards. The idea of the separation of monetary policy and liquidity policy has caught the
imagination of participants, with some suggesting that this is superior to the approach of the Fed
and Bank of England.
Experience suggests however that one should be cautious in taking the ECB at their word at
potential inflection points. In some ways the situation today might be seen in certain respects as
similar to that of July 2008, where the rhetoric was very hawkish and drew attention from the
gathering storm clouds on the horizon that were rapidly indicating the need for a reversal of
policy. Not that I am suggesting that a reversion to crisis mode is by any means a central
scenario, but it is unfortunately not out of the question, and clearly we are seeing signs of
inflation expectations coming down, of weakening peripheral growth, and of weakening
prospective growth in core Europe. This is consistent with the flattening of the 2s10s curve that
we have seen over the past year. I have seen work from other houses that suggests, based upon
the OECD output gap for the Eurozone and a measure of core inflation, that the ECB should be
keeping rates at zero whilst pursuing more direct unconventional easing policy.
There are certainly risks that Mario Draghi – likely successor to Trichet - will be forced to pursue
an ‘open mouth policy’ that is more hawkish than the Bundesbank would have been, in order to
placate a perhaps sceptical German audience. But arguably the slowdown will soon be upon us,
and in the meantime the ECB is already taking an unreasonably hawkish rhetorical position. To
the extent that you think this is a risk not fully priced by the market, it certainly tends to favour
holding longs further out the curve – whether in five years, or tens. The technical picture – both
in terms of the charts, and in terms of the markets sanguine reaction to hawkish rhetoric -
suggests however that the risk is fully priced, and that the greater danger – despite the anxiety
from some investors about further hawkish rhetoric – is that the ECB could be singing a different
tune over the coming months.
Flight to Quality Risks
As things stand, weakening retail sales in the periphery and an uncertain resolution to the
situation of debt issues in the Eurozone periphery suggest that there is scope for a pushing out of
the rate hikes currently priced in to the short end of the European rate curve. It may be wrong
to consider the following rather frightening possibility a central scenario, but should we see a
debt restructuring in Greece that leads to financial market and banking sector disruption in Spain
and Italy then there is a risk that markets start pricing in a scenario of Eurozone disintegration,
with the short end of the bund market becoming the ultimate safe haven within Europe. Whilst
this scenario is of course unlikely, its possibility is supportive of my bullish fixed income view.
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Relative Valuation
Looking at the leading indicators, growth is clearly slowing much more quickly in Europe than it is
in the US. A study by a competitor suggests that this tends to foreshadow significant
outperformance of European fixed income versus US Treasuries. With the Schatz/2y Treasury
spread at extreme levels, with an improving technical picture and having broken down recently
from a top formation I suggest that this trade – which I have been suggesting for a couple of
weeks now – has very much further to run over the course of this year. Sentiment is certainly
very much more positive in core Europe than it is in the US and with falling gasoline prices versus
the outlook for a deteriorating European periphery there is scope for surprises to be in the
direction of revising up US growth prospects and revising down US growth prospects. Clearly in a
continued global rally there is a limit to how much further US 2years can fall.
Weekly US-Germany 2y spread
Daily US-Germany 2y spread
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Best expression of my view
I have been emphasizing the attractiveness of long positions in the Schatz and the Bobl for some
weeks now - both as an outright long position, and expressed via calls and call spreads. I turned
somewhat cautious on Thursday with the Schatz at resistance levels from February and March,
but we closed above these levels on Friday and so it is time to return one’s focus to the bigger
picture bullish outlook.
I continue to favour buying dips in Euribor and the Schatz (but please bear in mind the risks of
bank credit concerns shifting the EURIBOR-EONIA spead). Although the market is certainly more-
extended on a short-term basis than when I first expressed my view, I do think it is early in the
development of this trend and do not think people yet have the trade on in significant size. It is
only in the past few days that we have begun to see the beginnings of significant positioning via
upside options flow.
If I am right about the nascent slowdown in Europe gathering pace, then one would expect to
see rate hikes continuing to be priced out of the front end, and then eventually an expectation
that rates are kept at low levels for some time before the next period of hikes begins. In that
context, I think it is significant that the shorter-term technical picture has shifted in recent days
suggesting that we may be early in a new steepening trend – it is clearest in 2s10s, but also
present in 2s5s. It’s worth remembering that despite the flattening over the past year the long-
term picture remains that we are in a steepening trend (and held the 38.2% retracement of the
initial steepening impulse post June 2008) , so I believe that steepeners have attractive
risk:reward over a multi-month horizon and may in addition be easier to hold than outright long
positions at this stage.
Daily 2s10s
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Weekly 2s10s
KALEIDIC ASSOCIATES MARKET UPDATE © Laeeth Isharc, 2011
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