Markets Roundup. Can US and German longer-term rates diverge? 14 July 2014 Research

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1 Markets Roundup 14 July 14 Research CONTENTS Market Movers Economics Weekly Calendar 6 Central Bank Policies 7 Forecast Table 8 Interest Rates (3M 1yr) 9 Gov t Bond Yields (yr 1yr) 1 Interest Rate & Bond Futures 11 Equities, Currencies & Commodities 1 DATA RELEASES United States 15/7 Retail sales 16/7 Producer prices 16/7 Industrial production 16/7 NAHB housing index 17/7 Housing starts/permits 18/7 UoM cons. confidence Eurozone 14/7 Industrial production 15/7 ZEW index (Ger) 17/7 Consumer prices (final) United Kingdom 15/7 Consumer prices 15/7 Producer prices 16/7 Labour market report RESEARCH Duncan de Vries Erwin Langewis E: nibc.research@nibc.com Can US and German longer-term rates diverge? Risk aversion suddenly rose after a Portuguese bank missed payments on its debt obligations. It was another reminder that central banks haven t created a risk free environment (p.1 p.5). The Chart of the Week shows 1-year US and German government bond yields. In the last MR of March, we asked ourselves the question whether ECB policy rates could remain low even when the US Federal Reserve starts raising rates. Even though the Fed s action tended to lead the ECB the past two decades, the German Bundesbank lowered policy rates in the early-199s, in contrast to the Federal Reserve. Today, we would like to shift our attention to the longer-end of the yield curve. Again, we can make the observation that bond yields in the US and Germany tend to follow the same trend. Interestingly, whereas central bank policy rates were not moving in the same direction in the early 199s, 1-year bond yields actually did move in tandem during that period. We have to go all back to the second half of the 196s when US and German interest rates didn t move in the same direction for a longer period. During that period, consumer price inflationary pressures started to pick-up in the US (the Great Inflation era) whereas German inflation rates remained close to % until around 197. Another observation we can make is that yield levels have come closer to each other, while the same counts for consumer price inflation rates since around the 199s. Against this background, we can conclude that - in addition to policy rates - also German longer-term rates can move independently from US rates for an extended period, despite that this hasn t happened often since the mid-195s. Weak eurozone economic activity and therefore low inflationary pressures should be the main reason behind a continuing low interest rate environment. Last week s developments in Portugal were, however, a timely reminder that rates can move for credit risks as well. Chart of the Week: US/Ger longer-term yields often move in tandem Percentage US 1-year government bond yield Germany 1-year government bond yield Source: Macrobond Important disclosures appear on the final page of this document

2 MARKET MOVERS: REVIEW & PREVIEW United States Financial markets have been hesitant to price in risks as they fully benefited from a globally accommodative monetary policy stance (see chart), but the materialisation of one of the many risks on the horizon may be enough to trigger a response in the markets. Last week alone, Chinese export growth (7.% yoy in June) was less strong than expected, Japanese Machine orders plunged the most on record in May (-19.5% mom), a tropical storm was nearing Fukushima, there were increasing tensions in the Middle East (Israel/Gaza Strip) and continuing tensions in Ukraine. Central banks leading financial markets Percentage Last week, however, there was a sell-off in equity markets and periphery bond markets, which was mainly caused by adverse developments in Portugal as the Portuguese bank Espirito Santo International missed payments on commercial paper. True, the Portuguese economy is small - nominal GDP is less than % of eurozone GDP - but at the same time financial market participants know from recent years that even trouble in small markets (e.g. Greece, the US sub-prime mortgage market) can quickly transform in big trouble. That said, for example Spanish bank Banco Popular and Actividades de Construccion & Servicios (a global operating construction company) delayed debt sales last week. Percentage change on a year ago Real GDP (yoy) - real fed funds rate (core CPI deflated) S&P 5 (RS) In the case of Greece and the US subprime market, troubles in the weakest links came to the surface first, but were quickly followed by problems in other indebted markets and asset classes. The crisis was not caused by subprime debt or Greece, but by a Ponzi scheme that resulted in 6 4 Financial market stress extremely low Index St Louis Fed Financial Stress Index excesses: high indebtedness and a loosening of credit standards driven by a search for yield. We are not saying that troubles in the Portuguese banking sector will definitely result in a near-term crisis, but at the same time, we don t feel confident at all to exclude the possibility of a crisis in the nearterm for whatever reason given worldwide imbalances. Debt levels are higher than before the credit crisis, while it isn t hard to compare today s search for yield in financial markets with the period before the crisis (see also the chart above) in our view. The chart on the left suggests that US financial markets have become increasingly dependent on the Federal Reserve s policies. Another look at the chart shows that the same situation applied to the 197s. That period was also featured by a loose monetary policy stance that resulted in rising inflationary pressures after which the Fed had to raise policy rates to a peak of % in Accordingly, maybe we have to add potential rate hikes and the end of QE to the already long list of risks. We discussed the rise in US student and car loans in last week s MR. Consumer credit data for the month of May revealed that borrowing surged again strongly (USD 19.6bn: the third highest monthly borrowing figure ever), led by non-revolving lending (which includes auto and student loans). It s a relatively small asset class, but again- it s a symptom of increased leverage and risk taking. As last week s developments in Portugal and troubles in emerging markets earlier this year made clear, not only US domestic problems can result in risk averseness. From that perspective, the underperformance of eurozone banks (see chart) might get increasing attention going forward as we move closer towards the ECB s asset quality review and stress test with banks threatened with fines by US regulators and especially banks in the periphery Markets Roundup 14 July 14

3 saddled with bad loans (e.g. around EUR 166bn in Italy). To end on a positive note, central banks have at the moment no intention to prick the bubbles it created (meaning that there is no threat from that side for a market correction) and economic growth is expected to remain positive the coming quarters. Underperforming European bank shares Index Jan-13 This week s macroeconomic agenda will focus on Yellen s Congressional testimony on Tuesday and Wednesday in which she will give her views on the economy. We expect the testimony to be slightly more hawkish than her recent speech, which may therefore result in speculation about earlier rate hikes. Nevertheless, we still expect the Fed to hike rates only in mid-15. Furthermore, retail sales are expected to have increased, supported by higher gasoline prices and auto sales. We will also be interested in industrial production data after production growth disappointed in Europe. Jan-14 STOXX Europe 6 index (LS) STOXX Europe 6 bank index (RS) Index deteriorate even further when another crisis hits economies. And as debt levels remain far too high in several countries - resulting in continuing risks for defaults - we are not comfortable with the search for yield that took place the last years in financial markets. True, it is all but certain that government bond yields will move to unsustainable high levels in the shortterm as current (visible) problems are probably still not large enough for investors to lose confidence in central bank s ability to keep financial market sentiment strong. But one of the arguments that were given for the aggressive pick-up in Portuguese bond yields since Wednesday was that liquidity in the bond markets is low. Indeed, we argued the past months that liquidity in other markets is low as well. For example, S&P 5 trading volumes have declined to the lowest levels since the late-199s. In addition, liquidity in the Japanese government bond market has declined, which can probably largely be explained by massive bond purchases by the Bank of Japan (see chart). There could be various reasons for declining liquidity in financial markets, but what we know for certain is that disappointing news can quickly and aggressively backfire in a low liquidity environment. Bank of Japan purchases result in less liquidity Trillion yen Trillion yen Eurozone Suddenly, something like credit concerns were witnessed in financial markets since Wednesday after Espirito Santo International delayed payments on short-term debt securities. Not only the bank s bonds plunged following this news, but there was also a sell-off in Portuguese government bonds. Bonds of other periphery bonds were dragged down with Portuguese bonds. It was another timely reminder that concerns about economy wide elevated debt levels can easily regain strength again in financial markets. The already stretched fiscal position of governments will Trading volume (long-term JGB, LS) BoJ balance sheet (RS) Whereas liquidity in the Japanese market is provided by the central bank (but a declining number of other parties are thus willing to purchase Japanese debt with also the (world s largest) pension fund moving out of its own countries bonds), eurozone countries remain fully dependent on public (bail-out loans) and private sector investors so far. To be clear, we don t want to argue here that the ECB should purchase government bonds (but that a whole different discussion). Markets Roundup 3 14 July 14

4 Nevertheless, we wonder what the ECB will do when bond yields jump again to around 7%. If the central bank starts purchasing debt, it would be hard to argue that they are not engaging in monetary financing. Indeed, subsiding governments by purchasing bonds in the eurozone remains far more difficult than in other parts of the world as discussed extensively the past years. Maybe therefore, eurozone investors are counting too much on the ECB s ability to prevent large scale defaults, despite their experiences with Greece. What is also important in the QE discussion in our view is that the Fed and BoE purchased government bonds to lower interest rates and create wealth effects. Yet, interest rates are already extremely low, while also other financial market asset prices have surged to stretched levels in our view. This explains why the ECB focusses on purchasing asset-backed securities as the central bank tries to support sectors that haven t equally benefited from monetary stimulus. It is therefore questionable whether overall economic growth will really be much stronger when the ECB employs QE. We don t believe it will and, in fact, we haven t seen any strong evidence that QE in Japan, the US or UK really worked. The US economy is still growing at a slower pace compared to the pre-crisis period, Japanese private sector activity hasn t recovered strongly, while the German economy performs in line with that of the US economy (without QE). Indeed, the creation of new money would most certainly have an effect on the euro s exchange rate. This might some short-term help to exporting nations, but it offers no longer-term solution. Just as keeping interest rates at artificially low levels will result in a misallocation of capital, manipulating exchange rate will provide a false illusion of improved competitiveness. And if depreciation a currency works (i.e. boost economic activity), the exchange rate will rise again and bring the underlying problems to the surface again. That said, recent industrial production data disappointed as Germany, France, Spain, Italy, the Netherlands and Finland all reported a monthly decline in production in May. Especially the German data were a big disappointed (-1.8% mom and also exports fell 1.1%) even though part of the production decline could be explained by another Industrial sector activity remains low Index Spain industrial production (excl construction) sharp fall in construction output (probably affected by weather effects). Unfortunately, business surveys have weakened the past months, suggesting that no strong rebound should be expected in the near-term. Monthly data can be volatile, but the chart shows that the industrial production recovery in Italy and Spain has actually hardly progressed. Following the latest manufacturing data, we decided to lower our Q GDP projection for the eurozone to.3% on a quarterly basis with risks on the downside. As regards Germany, although we kept the GDP growth rate projection unchanged at.3% for Q, risks have risen strongly that the German economic growth has slowed further. Italy is seriously flirting with another recession and the French economy may have grown only slightly after stagnating in the Q1. This week s agenda includes eurozone industrial production data. After all major eurozone countries reported a decline in production, we anticipate eurozone production to have fallen by about 1% in May. Furthermore, the German ZEW index may have slipped in July although not to levels we are getting nervous about. United Kingdom Recently the housing market has finally been determined as a big risk to the UK economy by the BoE. House prices retreated month on month, but prices increased 8.8% on a 3 month annualised level, according to last week s Halifax data. Although the IMF says the UK is likely to be the fastest growing economy in the developed world there are some worrying signs that growth is less sustainable than previously thought. Italy industrial production (excl construction) Interest rates have been kept at historically low levels for five years and GBP 375bn has been created Markets Roundup 4 14 July 14

5 out of thin air by the BoE. This is fine during crisis periods, but not for a booming economy. Fears that the main driver under the economic recovery, the housing market, is funded by cheap credit and easy money might be true. According to surveys 3% of households have reported to foresee payment problems if interest rates start increasing. Saving rate has been falling again Percentage Household saving ratio Secondly, the rebound in consumption growth over the past years is rather supported by the lower savings ratio (see chart above) and wealth creation due to rising equity markets and house prices instead of wage growth. The latter has been roughly flat in real terms. Not only households will be hurt by rising interest rates, but also the government. The UK government did build-up its debt problems as its budget deficit has been negative since 1 and currently stands at -6% of GDP leaving the debt/gdp level at 9%, up from only 37% in 1. A total of GBP 661bn, which is almost 4% of its total debt, needs to be refinanced within the next 5 years. Against the background of high public and private sector debt, higher interest rates could therefore easily derail the recovery. If the by the BoE created flood of cash kicks in on the back of a strengthening economy and inflation gets out of hand, policy rates need to be increased much quicker than currently expected. This could pop the UK s growth model. Last week the BoE left the interest rate unchanged at.5%, but speculation about higher rates before yearend has already led to a tightening of financial conditions by driving up the pound and government bond yields. This front running of expectations could leave policy makers believe that there is no urgency to hike rates soon. In addition to the interest sensitiveness of the UK s economy, there is also a strong imbalance in the current account balance. In May the UK s trade deficit rose to the highest level in four months showing that exports remain low as they rose.6% while imports climbed 1.7%. For over almost years the UK s trade balance has been decreasing on a structural basis (see chart). The value of imports has been much higher than the value of its exports, which implies that financing from foreign countries is needed to finance the UK s deficits. This negative trade balance could get another negative boost looking at slowing economic growth in the major eurozone countries, such as France, Germany and Italy. No rebalancing of the economy GBP bn Visible trade balance (goods) This week s agenda focusses on the labour market report and consumer prices. The annual CPI inflation rate was 5.% in 11. Since that moment, however, it fell sharply to % last May. A small uptick in inflation to 1.6% is pencilled in for June. On Wednesday the labour market report is due to be released. Employment has been rising strongly as the economy strengthened and productivity growth remained weak. A further drop in the unemployment rate to 6.5% is expected. Although this pace of employment growth looks too good to be true, employment components of surveys point to a further strengthening of the labour market. Secondly, vacancies are plenty which is also confirmed by anecdotic evidence. The paradox is that earnings growth has remained benign and that it is even negative in real terms. We anticipate wage growth, however, to pick-up in the second half of the year. Markets Roundup 5 14 July 14

6 ECONOMIC CALENDAR 14 JULY 18 JULY, 14 UNITED STATES Date Time Indicator BN Survey Prior Tuesday 15 July 14:3 US Empire Manufacturing Jul :3 US Retail Sales Advance MoM Jun.6%.3% 14:3 US Retail Sales Ex Auto MoM Jun.6%.1% 14:3 US Retail Sales Ex Auto and Gas Jun.6%.% 14:3 US Retail Sales Control Group Jun.5%.% 16: US Business Inventories May.6%.6% Wednesday 16 July 14:3 US PPI Final Demand MoM Jun.% -.% 14:3 US PPI Ex Food and Energy MoM Jun.% -.1% 14:3 US PPI Final Demand YoY Jun 1.9%.% 14:3 US PPI Ex Food and Energy YoY Jun 1.7%.% 15: US Net Long-term TIC Flows May -- -$4.B 15:15 US Industrial Production MoM Jun.3%.6% 15:15 US Manufacturing (SIC) Production Jun.5%.6% 16: US NAHB Housing Market Index Jul 5 49 : US Beige Book Thursday 17 July 14:3 US Housing Starts Jun 1K 11K 14:3 US Housing Starts MoM Jun 1.9% -6.5% 14:3 US Building Permits Jun 145K 991K 14:3 US Building Permits MoM Jun 4.% -6.4% Friday 18 July 15:55 US Univ. of Michigan Confidence Jul P 83 8 EUROZONE Date Time Indicator BN Survey Prior Monday 14 July 11: EC Industrial Production SA MoM May -1.%.8% 11: EC Industrial Production WDA YoY May.5% 1.4% 15: BE Trade Balance May M Tuesday 15 July 9:3 NE Trade Balance May B 11: GE ZEW Survey Current Situation Jul : GE ZEW Survey Expectations Jul Wednesday 16 July 11: EC Trade Balance SA May 16.5B 15.8B Thursday 17 July 8: EC EU7 New Car Registrations Jun % 9:3 NE Unemployment Rate Jun 8.6% 8.6% 11: EC Construction Output YoY May -- 8.% 11: EC CPI MoM Jun.1% -.1% 11: EC CPI YoY Jun F.5%.5% 11: EC CPI Core YoY Jun F.8%.8% Friday 18 July 1: EC ECB Current Account SA May -- B UNITED KINGDOM Date Time Indicator BN Survey Prior Tuesday 15 July 1:1 UK BRC Sales Like-For-Like YoY Jun %.5% 1:3 UK CPI YoY Jun 1.6% % 1:3 UK CPI Core YoY Jun 1.7% 1.6% 1:3 UK RPI YoY Jun.4%.4% 1:3 UK RPI Ex Mort Int.Payments (YoY) Jun % % 1:3 UK PPI Input NSA YoY Jun -4.7% -5.% 1:3 UK PPI Output NSA YoY Jun.5%.5% 1:3 UK PPI Output Core NSA YoY Jun 1.% 1.% Wednesday 16 July 1:3 UK Claimant Count Rate Jun 3.1% 3.% 1:3 UK Jobless Claims Change Jun -7.K -7.4K 1:3 UK Average Weekly Earnings 3M/YoY May.5%.7% 1:3 UK Weekly Earnings ex Bonus 3M/YoY May.8%.9% 1:3 UK ILO Unemployment Rate 3Mths May 6.5% 6.6% 1:3 UK Employment Change 3M/3M May 5K 345K Source: Bloomberg News Weekly snapshot of financial market developments in the United States, euro zone and United Kingdom

7 CENTRAL BANK POLICIES United States FOMC Policy interest rate: Federal funds target rate Last action: -75/1 bps on 16 December 8 Next Meetings: 3 July, 17 September, 9 October Policy Outlook: The Fed funds rate has been cut to an unprecedented target range of -.5%. Furthermore, the Fed started to purchase assets and after Operation Twist ended in 1, decided to increase the size of asset purchases per month by a further USD 4bn. A total of USD 35bn of agency MBSs and Treasury securities are purchased per month. Interest rate hikes are not expected before mid-15, but risks have shifted somewhat to Q 15. FOMC minutes: August, 8 October Eurozone ECB Policy interest rate: Main refinancing rate Last action: -1 bps on 5 June 14 Next Meetings: 7 August, 4 September, October Policy Outlook: The ECB has cut the refi rate to only.5% on May 13 after the bank already reduced the reserve ratio, eased eligibility criteria, purchased government and covered bonds and offered unlimited amounts of loans/liquidity to commercial banks the last years. The ECB said it expects key ECB interest rates to remain at present levels for an extended period of time. The ECB is still relatively dovish, meaning that there are risks for more actions later this year. No rate hikes are expected before 16 at least. United Kingdom - Bank of England Policy interest rate: Repo rate Last action: -5 bps on 5 March 9 Next Meetings: 7 August, 4 September, 9 October Policy Outlook: Even though inflation rates are expected to remain at elevated levels, we expect the BoE to keep rates unchanged at.5% for the foreseeable future given a still weak economic recovery. The MPC purchased about GBP 375bn of assets. Rate hikes are expected in Q 15, but risks have shifted to Q1 15. BOE minutes: 3 July, August, 17 September Markets Roundup 7 14 July 14

8 FORECAST TABLE United States Yearly averages Q3 Q4 Q1 Q Q3 Q4 Q1 Q Q3 Q4 GDP (quarter-on-quarter) (year-on-year) Consumer Price Inflation (year-on-year) Federal funds rate * yr Treasury yield * Eurozone GDP (quarter-on-quarter) (year-on-year) Consumer Price Inflation (year-on-year) ECB refi rate * Germany GDP (quarter-on-quarter) (year-on-year) Consumer Price Inflation (year-on-year) yr bond yield * Netherlands GDP (quarter-on-quarter) (year-on-year) Consumer Price Inflation (year-on-year) United Kingdom GDP (quarter-on-quarter) (year-on-year) Consumer Price Inflation (year-on-year) BoE bank rate * yr bond yield * *end of period Markets Roundup 8 14 July 14

9 INTEREST RATES (3M 1YR): ACTUALS & CURVE Policy Interest Rates (%) 3m Interest Rates minus Policy Rate (bps) m Interest Rates (%) 1m minus 3m Interest Rates (%) USD Libor Euribor GBP Libor 1m Interest Rates (%) 1 yr Interest Rate Swap Spread (bps) USD Libor Euribor GBP Libor Eurozone United Kingdom Source: Bloomberg Update: 7/14/14 8:4 Markets Roundup 9 14 July 14

10 GOVERNMENT BOND YIELDS (YR 1YR): ACTUALS & CURVE yr Benchmark govt Bond Yields (%) 1 yr minus yr govt Bond Yields (%) yr Benchmark govt Bond Yields (%) 1 yr Interest Rate Swap Spread (bps) Real govt indexed Bond Yields (%) Estimate of Inflation Expectations (%)* US TIPS 17 (indexed to CPI) FR OATei 17 (indexed to Euro CPI) UK IL Gilts 17 (indexed to RPI) United States (CPI) Eurozone (CPI) United Kingdom (RPI) * Difference between nominal government bond yield and inflation-indexed bond yield ("breakeven inflation") with the same maturity (17) Source: Bloomberg Update: 7/14/14 8:4 Markets Roundup 1 14 July 14

11 INTEREST RATE & BOND FUTURES: MARKET EXPECTATIONS United States: 3m Eurodollar* United States: 1yr treasury yield* Current SEP 14 DEC 14 MAR 15 JUN 15 SEP Current SEP 14 DEC 14 MAR 15 Euro zone: 3m Euribor Euro zone: 1yr govt Bond Yield Current SEP 14 DEC 14 MAR 15 JUN 15 SEP Current SEP 14 DEC 14 MAR 15 United Kingdom: 3m Sterling United Kingdom: 1yr GILT Yield Current SEP 14 DEC 14 MAR 15 JUN Current SEP 14 DEC 14 Current ** Two weeks ago One month ago * Forward interest rates and bond yields implied by futures contracts. Source: Bloomberg Update: 7/14/14 8:4 Markets Roundup July 14

12 EQUITIES, CURRENCIES AND COMMODITIES Major Equity Markets Major Currencies S&P 5 (LS) FTSE Eurotop3 (LS) FTSE1 (RS) EUR/USD (LS) EUR/GBP (RS) USD/GBP (RS) Commodity Prices Oil Price* /7/1 31/7/ DJAIG Index Spot price (USD) Spot price (EUR) Source: Bloomberg; Update: 7/14/14 8:4 * West Texas Intermediate (WTI) Cushing Crude Oil Spot Price Disclaimer Certain statements in this presentation prepared by NIBC Bank N.V. ( NIBC ) are not historical facts but forward-looking statements. Words such as believe, anticipate, estimate, expect, intend, predict, project, could, may, will, plan and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. These statements are largely based on NIBC s current view with respect to future events and financial trends that we believe may affect the economy, the credit market in general and interest rates. By their very nature, forward-looking statements involve uncertainties and are subject to certain risks, including, but not limited to, the risks and uncertainties as addressed in this presentation, and/or changes in general economic conditions, changes in credit spreads or interest rates. The forward-looking statements speak only as of the date of this presentation. NIBC does not undertake any obligation to update or revise forwardlooking statements contained in this presentation, whether as a result of new information, future events or otherwise. The information and opinions presented here have been obtained or derived from public sources believed by NIBC to be reliable at the date of publication of this presentation. No warranty, prediction or representation is made as to their accuracy or completeness and they are subject to change without notice. NIBC does not make any representation, warranty or prediction that the results anticipated by such forward-looking statements will be achieved, and such forward-looking statements represent, in each case, only one of many possible scenarios and should not be viewed as the most likely or standard scenario. NIBC accepts no liability for (direct, indirect or consequential) loss arising from the use of the information and figures presented. This material is not to be relied upon in substitution for the exercise of independent judgment. When preparing this presentation NIBC has not taken into account any customer s, creditor s or investor s objectives, financial resources or other relevant circumstances and the opinions and recommendations herein are not intended to represent recommendations for particular creditors, customers or investors. NIBC is the owner of all works of authorship including, but not limited to, all design, text, sound recordings, images and trademarks in this presentation unless otherwise explicitly stated. The use of NIBC s material, works or trademarks is forbidden without written consent, except were otherwise expressly stated. Furthermore, it is prohibited to forward or publish material made or gathered by NIBC without its prior written consent. Markets Roundup 1 14 July 14