Macro Weekly – Turbulent markets, indicating what?

by: Han de Jong

Financial market have been relatively volatile in recent days. Core eurozone bond yields have risen sharply and equities, European ones in particular, have lost ground. Investors need to think what has caused this and what the implications are. I fail to see a clear connection with recent or future developments in the real economy. Yes, the US economy has made a very slow start to the year, but is expected to gain momentum in the period ahead. The Fed did not give clear hints about what it might do next. Eurozone data continues to confirm that the economy is recovering and the sidelining of Greece’s finance minister appears to be giving the negotiations between the country and its partners a boost.


The message

I am a great believer in the collective intellect of financial markets, though I sometimes, arrogantly, think that the three of us (I, me and myself) know better than all the market participants together. Recent market action is a bit of a puzzle: despite continued ECB bond buying and increasing scarcity in some segments of the eurozone bond market, yields on core bonds have risen relatively sharply over a short period of time. Meanwhile, spreads of Spanish and Italian bonds over Germany did not widen. Spreads of Greek bonds, on the other hand, actually tightened significantly. This has coincided with a strengthening of the euro. Such a combination points to an easing of fear for something. Core eurozone bonds have benefitted in the past not just from ECB buying, but also from safe-haven flows as the negotiations between Greece and its partners failed to make substantive progress. The dollar may also have benefitted from the Greek saga and is now losing ground.

Why equities should sell off sharply just when confidence about the economic future of Greece seems to be getting clearer is not obvious. Some commentators are saying that weak US growth has driven equities down. However, that seems to be at odds with the fact that European equities are losing more ground than US equities. I suspect that there is a big element of ‘taking a breather’ in all of this. The Euro Stoxx 50 index rose more than 21% between the end of last year and the peak in mid April. Despite recent losses, the market is still up almost 15% for the year. Some profit taking in bonds was perhaps also overdue as the 10yr Bund yield was heading for zero yield at an impressive pace.


Perhaps I am arrogant, but I do not believe that market action is signalling economic problems ahead. Yes, the US economy slowed significantly in the early months of the year. It is clear, however, that weaker growth was at least partly caused by temporary factors. A rebound in growth is on the cards, it is just a question of how much. Recent US data was broadly supportive of our optimistic view. Private consumption rose a relatively robust 1.9% in Q1. House prices continue to rise modestly, the Chicago PMI recovered in April to 52.3 from 46.3 in March, the nationwide ISM stabilised at 51.5 in April, personal spending rose 0.4% mom in March while initial jobless claims fell to their lowest level since 2000 last week.

The FOMC met this week and released a statement that gave something to everybody. Clearly, the economy was weak early in the year; clearly this was partly due to ‘transitory’ factors; clearly the exceptionally low interest rates are, or will soon be, unwarranted by domestic economic conditions. The FOMC omitted from its statement a phrase from the previous statement that ruled out a rate hike at the following meeting. Does that mean they will raise rates in June? Not necessarily. My reading is that, despite the FOMC’s unanimity at the April meeting, the committee is extremely divided. This makes policy very unpredictable. Our view remains that rates will not be raised in June, but in September. And even that requires an improvement in growth momentum for the economy along the lines we are expecting. And even then, doves may argue that there is little harm in holding off a little longer. Apart from the fact that the Fed is relatively unpredictable due to internal differences of views, I cannot see what the markets should worry much about. True, the first rate hike in almost ten years creates uncertainty, but it is not as though the Fed will hike aggressively or that we will be taken by surprise.

Eurozone credit channel improving

We have highlighted for some time that the credit channel in the eurozone is healing. The March monetary statistics confirm this view. Broad money growth, as measured by M3 growth, accelerated to 4.6% yoy, up from 4.0% in February, 3.6% in January and a trough for this cycle of 0.8% in April last year. M1 growth, which is actually a better guide to overall economic growth than M3, accelerated to 10.0% yoy, up from 9.1% in February. Bank lending details were also encouraging. Bank lending growth in many market segments is now entering positive growth territory on a yoy basis. This should not be mistaken for feeble growth. What we measure as credit growth is, in fact, the difference between new loans and the expiration of old ones. This measure lags the business cycle as a whole and tends to underestimate the strength of the economic recovery following periods of contraction and weak growth.

Particularly encouraging data came from Spain this week. GDP growth in Q1 exceeded expectations. On yoy basis, GDP was up 2.6%, well ahead of the 2.0% in Q4 and the best since 2008. Deflation fears are receding in the eurozone, one could say almost as quickly as they appeared last year. Eurozone headline inflation moved back to 0.0% yoy in April, having spent four months in negative territory. Stronger economic growth, higher oil prices and the weaker euro are making an early return to the deflation scare unlikely.


From Grexit and Voodoofakis to Varoufexit

Yanis Varoufakis, the Greek finance minister was sidelined regarding the negotiations between Greece and its partners. This seems to have led to a material improvement in the progress made at these talks, although we have to wait and see if Varoufakis’ successor in this role, Euclid Tsakalotos, can keep momentum going. Opinion polls are suggesting that the Greek electorate has become less supportive of the confrontational approach the Greek negotiators took under Varoufakis. The electorate seems determined that Greece stays in the euro and an increasing part of the electorate is starting to realise that that can only be achieved through compromise. The outlook here is a good deal better than it has been in months.