Interest and Currency Outlook for Q2 2010:
Euro turbulence delays key rate hikes by ECB
- First interest rate moves expected in Q4 2011; interest rate hedging at an extremely low level makes sense in light of high risk
- But no negative effects on economic recovery
- ECB's credibility still not affected by intervention; CDS levels in all eurozone countries have declined
- A euro is a euro and will remain a euro – no signs of growing inflation worries
According to UniCredit Group's current estimates, the massive turbulence surrounding the euro will have no direct negative effects on the economic recovery. Instead, the upward revisions in the various growth forecasts should continue, although economic growth will vary considerably from region to region. "The Bank Austria Business Indicator, for instance, hit a two-year high in April. In particular the strong increase in consumer confidence and the improved sentiment in industry are offering more favourable short-term growth prospects again," said Helmut Bernkopf, Bank Austria's director for Corporate & Investment Banking. "We still anticipate that Austria's GDP will grow by 1.3 per cent in 2010."
However, the escalation of the crisis has disrupted the exit strategy of the European Central Bank (ECB) from its low-interest policy, and the first key rate hikes are now expected to come at the earliest in the fourth quarter of next year instead of the first quarter. Ultimately, the situation has stabilised as a result of the ECB and not the massive aid package totalling EUR 750 billion. "By deciding to purchase government bonds when necessary, the ECB has responded to the crisis in the same way as the Fed and the Bank of England did in 2009. Whether or not this will affect the ECB's reputation remains to be seen over the long term. The credibility of all of the eurozone countries has improved, at least in terms of their declining CDS levels," said Bernkopf, summing up the situation.
Bonds: Emergency measures will calm the eurozone's peripheral markets
By purchasing government bonds, the ECB and the national central banks do not aim to achieve any particular performance, but instead to keep the bond bears in check. The ECB displayed its determination for the first time on Monday of last week when it lowered the yields on two-year Greek government bonds by over 10 percentage points. "And this success is very likely to continue. After all, the European Central Bank has an endless supply of resources at its disposal," said Michael Rottmann, the Global Head of Fixed Income & Forex Strategy at UniCredit Group. "In addition, the central bank purchases have come at a time of extremely low liquidity levels."
At the same time, a possible selling interest from real money accounts at considerably lower levels should be manageable. In addition, strong peer pressure may deter investors who are battling against the benchmark, such as investment funds, from a stronger underweighting of the peripheral markets of Greece, Ireland, Italy, Portugal and Spain. In light of excessive weekly performance on the relevant markets, investors run the risk of falling too far behind the benchmark and finding themselves at the bottom of the performance rankings day after day over the coming months.
In its purchasing plan, the ECB may very well have a framework of relative yield levels in mind. "Spain, Portugal and Ireland would definitely have found it ‘unfair' if they had had to seek financing on the market at higher costs than the price that Greece has had to pay for its aid package," believes Rottmann. "I would set the cap for yields in these countries at swap plus 300 basis points plus 50 basis points in management fees for terms of up to three years and at swap plus 400 basis points plus management fees for terms exceeding three years." Accordingly, the yields for the affected countries should trade well below this level in the future.
Unlike the Fed and the Bank of England in 2009, the ECB is making purchases at unequally attractive yield levels, so an early sale is unlikely. Instead, one can assume that the purchased bonds will be held until maturity.
No indications of higher inflation expectations; confidence rises in eurozone countries
Despite the measures to stabilise the common currency, there have still been no signs of higher inflation expectations in spreads between general and inflation-protected government bonds or in inflation swaps or forwards on inflation-indexed bonds. In addition, money market forwards declined considerably last week – which is also not an indication of growing inflation worries.
"At the moment, there are also no signs of higher risk premiums as a result of the dwindling credibility of the eurozone as a whole," said interest rate expert Michael Rottmann. For example, CDS levels in the eurozone have not only fallen in the countries that were directly affected by the central bank's purchases. They have also declined markedly in all of the eurozone countries despite the fact that yields in the core countries have risen. However, this combination is also a clear sign that the core eurozone countries have lost their status as a safe haven.
Higher gold price does not conflict with optimistic view of inflation and credibility risk
According to Rottmann, the higher gold price does not conflict with his optimistic view of inflation and credibility risk at the moment. The gold price has risen precisely as a result of the fact that the financial world has calmed down following the ECB's bond purchases. A more stable environment in general ultimately benefits gold, because, in the broadest sense possible, gold is a risky asset class that profits from calmer conditions on the financial markets, when the liquidity available has the chance to flow into more volatile asset classes. In addition, gold can certainly be seen as one of the most interesting asset classes in terms of risk and return when it comes to probability-weighted macro scenarios.
Actually, gold only makes a vulnerable impression under extreme conditions – for instance, a brief period of shock on the financial markets involving extreme illiquidity in many asset classes and the necessity to reduce risk at all costs. It is only under these conditions that gold seems to come under selling pressure, when the price is still favourable and the liquidity situation satisfactory.
Conclusion: Stronger increase in money market and swap rates will only occur towards the end of 2011, but risk scenarios remain extreme. In light of this, a partial interest rate hedge makes sense!
UniCredit Group now expects the ECB's first key rate hike to come at the end of 2011. Its experts also anticipate that the ECB's exit strategy from its low-interest policy will be delayed deep into 2011. Since interest generally remains fixed for tenders with full allotment, the three-month Euribor rate is not expected to decline to the level of the key rate until the early part of next year. The swap rates and yields in the core countries will therefore rise later than previously forecast. Michael Rottmann predicts that the 10-year swap rate will hit 3.45 per cent at the end of this year and 3.80 per cent at the end of 2011. He believes that this weaker increase will be the result of a slower return to a "new normality".
This estimate does not include a rising inflation risk premium and/or the credibility risk premium engulfing the entire eurozone. The interest rate expert still sees these two factors as pure risk scenarios. However, these kinds of scenarios are already priced into current yields. And in all honesty, in light of the various uncertainties at the moment, the risk scenarios are significant. In this environment, it is not possible to categorically rule out rising interest rates as a result of growing inflation worries and/or a renewed credibility crisis. "The star economist Nouriel Roubini, for instance, still anticipates that some countries will leave the eurozone. And other prominent commentators still expect a restructuring of Greek debt," said Bank Austria director Helmut Bernkopf. "If market expectations turn in this direction, the result would be a very distinct increase in interest levels." So those who not only keep the short-term basis scenario in mind, but also incorporate the imponderable risk scenarios into their decision-making process, will be able to take advantage of the extremely low interest level at the moment to hedge their interest costs.
A euro is a euro and will remain a euro
If one were to search for signs of a general loss of confidence in the eurozone, the currency would be the best place to look. Unlike in the case of government bonds in the eurozone, direct interventions would not be promising over the medium and long term due to the high volumes in the main currencies. This means that all of the risk scenarios described above could impact the euro. "Market participants expect a very clear policy statement about how to solve the manifold problems within the eurozone – current account imbalances, relative fiscal policy, varying levels of competitiveness," said Michael Rottmann. "As long as there is no clear, logical answer, the common currency will not experience a sustainable stabilisation." The structural problems have therefore also clearly shown that over the coming years the euro will hardly be able to pose a serious threat to the US dollar in its role as the world's top currency reserve. In addition, interest rate expectations are currently diverging greatly. While the key rate in the US is expected to start normalising at the latest in the first quarter of 2011, virtually no one is predicting that a key rate hike will occur in the eurozone before the end of 2011.
But there is no need to get worked up. The EUR-USD exchange rate is still marginally higher than its initial value of around 1.19 on 1 January 1999. Consensus also puts the purchasing-power parity at 1.15. From this perspective, the euro was overvalued for years and at the moment is simply returning to its "fair" value. But the euro should still not be considered a soft currency. Instead, a distorted perception on the part of market participants has led to the rapid, broad-based decline of the euro. The euro is currently not being viewed as a shared whole but as the sum of its weakest parts (Spanish unemployment rate expected to come in at around 20 per cent in 2011, Greek government debt expected to hit 130 per cent of GDP in 2011).
Although Greece is often compared to California, in times of crisis the euro always suffers from the serious malady of having too many decision makers. In contrast to one president in the US, the eurozone has 16 + X decision makers. The X here stands for Brussels. So it is the purely mathematical possibility of conflicting statements that constantly places a burden on the euro during times of crisis. Ultimately, however, the debt levels in the US, Great Britain and Japan show that these countries are also facing problems. At the moment, it is impossible to predict whether or not the AAA ratings for Great Britain and the US will come into question in two years' time. Consequently, UniCredit Group anticipates a stabilisation in the range of 1.10 to 1.20, but does not expect the euro to fall below parity for a period extending over several months. The euro is also likely to post gains against the Swiss franc and the Japanese yen over the course of 2011.
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