March 2011
Expectations of an increase in the ECB's key rates /// The point of view of Natixis Asset Management. "Following the monetary policy committee meeting on March 3, 2011, ECB President J-C. Trichet announced that key rates may be raised as of next month ‌"
1/ Macroeconomic analysis
by Philippe Waechter, Chief Economist Macroeconomic reasons underlying the ECB focus Higher commodity prices The first reason is obviously the hike on commodity prices, as shown by the ECB's inflation expectations for 2011, though this does not extend to 2012. When forecasts were made in December last, the mid-range inflation calculated by the ECB was 1.8%, subsequently moving up to 2.3%. Looking ahead to 2012, this mid-bracket figure increases from 1.5% to 1.55%. Leaving aside the price of commodities, the ECB mentions the medium-term risk of higher inflation if economic activity recovers and brings pressure to bear on prices due to higher demand, but also due to higher taxation which could be necessary for the purposes of budget consolidation. Recovery of business
Business activity and monetary policy in the Eurozone 65.00
2
Business is on the move again. Thus 1.5 1 monetary policy is too accommodating 60.00 0.5 with a 1% refi rate. Here we refer to the 55.00 0 chart on the right, which shows great 50.00 -0.5 regularity, and the relationship between -1 Eurozone business surveyed by 45.00 -1.5 PMI/Markit and changes in the refi rate -2 over 6 months. The survey depicts 40.00 -2.5 Global synthetic index - PMI/Markit survey 2 months ahead inflexions in business activity, and the 35.00 ECB refi rate - difference over 6 months (scale on right) -3 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 ECB adjusts its refi rate to the inflexions. This is an extremely interesting chart, Source: Datastream – Natixis Asset Management since it suggests that, in due consideration of the credibility acquired and maintained by the ECB, inflation will not drift too far from the 2% threshold, and thus the focus of monetary policy is chiefly conditioned by business activity.
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The perception of monetary policy which is genuinely too accommodating
ECB refi rate - nominal and real 5.00
The situation of the ECB committee members was increasingly uncomfortable in view of the perception of a monetary policy which was genuinely too accommodating. These were the sentiments expressly recently by the President of De Nederlandsche Bank, Nout Wellink, who claimed that, since business was on the up and up, a sterner tone should be rapidly deployed. Consequently the ECB's key rate was too low to have any effect on the economic situation. We can grasp this situation by taking a look at the real ECB refi rate shown on the chart to the right.
Nominal 4.00 3.00 2.00 1.00 0.00 -1.00 Real (excl. inflation) -2.00 2004 x 2005 2006 2007 2008 m 2009 1999 2000D2001 2003 Source: atas2002 tream – Nati is Asset Manage ent2010 2011
Source: Datastream – Natixis Asset Management
Why didn't we agree with this analysis? All the items are well known, but it was not the scenario we were imagining. 3 factors prompted us to advocate that an accommodating monetary policy be maintained. Business activity is still limited The first factor is that business activity is still Eurozone - Trend in GDP limited. In all Eurozone countries, even 2100 Annualized growth rate of the trend calculated for 2000 - Q1 2008: 1.8 % Germany, it still falls short of pre-recession 1.7% (annual rate) 2050 Growth from low point (Q2-09): 2000 levels. The Eurozone suffered a brutal and 1950 persistent impact, of such violence that it has 1900 as yet been unable to regain its previous 1850 level of activity. The gap between the last 1800 1750 quarter of 2010 and the highest point of the 1700 first quarter of 2008 is -2.9%. This means 1650 Measure of output gap - 5.8% (gap at end of 2010 between level of GDP and Trend) that internal demand is poor. Consumption is 1600 making a moderate comeback, but 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 investment is still very much in the Source: Datastream – Natixis Asset Management doldrums. It was this state of affairs, and the heterogeneity of growth among Eurozone countries, which prompted us to advocate prudence, and not validate the regularity of the first chart above. Limited dynamics on the job market The second factor is that job market dynamics are still limited. Employment is having difficulty regaining ground. The lower unemployment figures released in January (9.9%, as against 10% since April 2010) are still insufficient to signify a solid substantial recovery on the job market.
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Price formation The third factor is price formation. If we take a look at the rate of inflation in the Eurozone, we observe that although contributions by commodities (foodstuffs and energy) have increased, underlying rate contributions are still low. If the objective is to stabilize inflation, but the increase in energy and food prices is exogenous, then the only resort is to put pressure on underlying inflation and therefore on pay. This solution would not feed internal demand, and would not enhance the autonomy of growth in the Eurozone.
2/ Investment management views by Fixed Income Investment Department
Towards an increase in the ECB's key rates Following the monetary policy committee meeting on March 3, 2011, ECB President J-C. Trichet announced that key rates may be raised as of next month in a bid to contain the higher inflation observed in recent months. This turn of events comes as a surprise to us, since our forecasts had predicted status quo on the monetary front in 2011. The absence of any ULC tensions and the intensity of the Eurozone crisis would appear to favor a more prudent policy, and all the more so since the US Federal Reserve looks set to pursue an extremely expansionist policy until June next. Thus the Euro's increase and higher rates could adversely affect the economic situation in Europe as of the latter half of the year. Linguists specializing in ECB rhetoric likewise took due note of the absence of the word "appropriate" in relation to the current rates, and of "close monitoring" by members of the monetary policy committee with regard to the risk of inflation in the medium term described as upwardly mobile in view of present levels of growth. The use of the expression "close monitoring" has almost always preceded (except on one occasion) a rate increase the following month.
What are the impacts? It is obvious that the change of tone observed in recent weeks will have certain consequences in terms of interest rates, probably as of the second quarter of 2011. The ECB inflation forecast for 2012, however, is bang on target since the Bank is considering average inflation of 1.7% in 2012 (mid-bracket). The linguists had earmarked 1.8% as the fateful threshold for an increase cycle. M3 (+1.5% YoY) and credit (+2.5% YoY) only increase slightly. Contrary to J-C. Trichet's remarks, we feel that an initial increase would necessarily unleash expectations of a tightening cycle, probably at a linear pace of 25bp per quarter. Only a major setback could curtail this. Morgan Stanley and CrĂŠdit Suisse have now corrected their repo rate forecasts to 1.75% by year-end. It should be noted that this pace would set an immediate target of 2% for the Schatz, or 2.15% to include a risk premium, and would initiate a curve flattening process.
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Meanwhile, no changes to the liquidity offer for banks: 3M LTROs(1) have been extended (rate reviewable in accordance with MROs(2) if the ECB alters its rates or goes into auction mode), and will take place on April 27, May 26 and June 29. STROs(3) (1 month) and MROs(2) (1 week) are still unlimited at the refi rate until July 12. It is clear that the ECB is not attaching much importance to the recessions (or depressions) in Greece, Portugal and Ireland. The Bank has no interest in the global Eurozone policy mix (on the pretext of its independence) and, which is much more serious, in the financial stability of the zone. The problem of monetary tightening nowadays is the policy mismatch: most banks that will be affected by the rates hike are those which are excluded from the unsecured interbank market and are facing the prospect of a dwindling deposits base, making them extremely dependent on ECB repos (Greek banks finance almost 20% of their balance sheet courtesy of the ECB, Ireland 12%, and Portugal 9%). Also, if Spanish household NPL rates remain relatively contained, the increase will not be harmless in view of the indexation of real estate loans, the vast majority of which are arranged at variable rates in Spain. The Irish have the same problem, with the difference that their NPL rate is already riding high. In short, we are of the opinion that we could be in for a cycle of increases which will be cut short at the first setback (+25bp in April, July and October, towards 1.75% by the end of 2011, and 2.75% by year-end 2012). The return of systemic risk, already glimpsed in interbank tensions, is a possibility. The only contingency that could disturb the tightening cycle is a power struggle between the ECB and governments. Against a backdrop of a packed political calendar in March, the Bank may wield the threat of monetary tightening to force governments to take decisive action and provide a budgetary solution to the problem of sovereign solvency (extension of common guarantees, fiscal transfers). The impact of the ECB's announcement is nevertheless limited on the long section of the curve. 10Y German rates, which had moved up from 3.25% to 3.33%, are now back in close proximity to their initial levels. Only 2Y rates have increased from 1.58% to 1.79%, thereby integrating 2 extra ECB rate increases.
Markets outlook Bond market In management terms, therefore, we are making no changes to our slightly negative view at one month on the German 10Y rate. With regard to the short portion of the Euro rates curve, potential additional tensions on rates could even lead us to envisage a buying position at 2% on the German 2Y in our bond portfolios. Money market With regard to money market UCITS, the process includes means in response to such action by central banks by their nature. The performance of EONIA-indexed UCITS will naturally follow suit behind the increase in the EONIA - if it does increase. Fixed/floating UCITS look set to experience the increase in the sense of a larger proportion of EONIA-linked assets. The trajectory of the EONIA/3M Euribor spread will also determine the relative performance with respect to the EONIA for 3M referencelinked UCITS.
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(1) (2) (3)
LTRO: Longer-Term Refinancing Operations MRO: Main Refinancing Operations STRO: Short-Term Rental Overlay
Written on 07/03/2011 by Fixed Income Investment and Economic Research Departments at Natixis Asset Management
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