Testing time for ECB in aftermath of storm
The euro markets haven’t had to wait long for the first major euro interest rates storm to break. The equity markets’ euphoric reaction to Red Oskar’s sudden departure was contrasted in the immediate aftermath by the lethargic mood in the euro bond market.
Traders saw this as a welcome pause for breath after recent volatility. German bunds attempted to consolidate the gains posted after the resignation, and the renewed hope of a sooner rather-than-later rate cut from the European Central Bank. However, realism was just around the corner, with the realisation that the appointment of Hans Eichel as Lafontaine’s successor is unlikely to lead to a rapid solution to Germany’s economic woes.
The ECB’s situation is a classic stand-off between the political and the structural; a situation that must now be tested. Rod Davidson, of Murray Johnstone, suggests the central bank should not be rushed: “The ECB can hold back and reaffirm its position.” He believes the ECB has the ability to stave off any suggested crisis of confidence. At this stage, although fund managers fully expect the ECB to cut rates to as low as 2.5% in the next few weeks, the bank itself has given no indication of its intention, leaving the market to speculate how it will react, within the Machiavellian scenario where it was felt that rates had been maintained simply to spite Germany.
Up to the time of Lafontaine’s resignation, the biggest influence on European markets had been the US, where the key indications are that there is no real slowdown in economic activity. Daniel Knuchel, at Credit Suisse Asset Management in Zurich, says: “We feel that has had some effect in reducing yields in Europe and the US, but less so in Europe as you can see the yield spreads have not been affected as badly.”
An important factor re-mains the stance of the ECB especially in relation to the continuing pressure to lower rates. Lafontaine felt the ECB should have reduced rates, as did the Fed, though they didn’t make such a fuss about it.
On the other hand, says Knuchel, “although there has been evidence of a slowdown in economic growth and higher unemployment trends, particularly in Germany, the numbers are not actually that bad. So I’m not sure the ECB will reduce. As long as the numbers don’t point to a market slowdown, I don’t think we’ll see a further cut in rates, so we’ll have some helpful effects in terms of a weaker euro.”
ABN Amro’s view is: “The chances of an ECB rate cut have clearly diminished, despite mounting political pressure. However, inflation in Euroland continued to fall and virtually disappeared in France and Germany, dropping to 0.2% in January in both countries. Once US rate fears subside, we may very well see some rebound of interest rates in Euroland. January levels are unlikely to be touched again, however, unless the global picture were to take a turn for the worse in Latin America or Asia.”
It would be an exaggeration to say the extent of the weakness in the euro is that significant, according to Knuchel: “If we see a slowdown in Europe, then we will see a cut in yields. The popularist politics of some politicians in Europe are pushing for a cut. But I think it would be unwise to do so and I don’t think Duisenberg is the man who will do it. I think it’s important for the ECB to reaffirm its independence.”
The weakness of European bonds is partly as a result of the US growth in Q4 98 filtering into Q1 99.
Davidson says: “The back- up in yields given the state of growth scenario in Europe is attractive, especially because inflation is below 1% and unemployment in Germany and France is rising. The growth outlook is not fantastic. In fact one major German research house has reduced its growth forecast for Germany from 2% down to 1%. We have increased our exposure to Europe in this period.”
Germany is flirting with recession and Italian growth is slowing, but elsewhere the slowdown is less acute, according to ABN Amro: “Nevertheless the euro area is the first major OECD economy to follow Japan into negative growth territory. This has added to political pressure on the ECB. Against this, the recent weakness of the euro against the dollar - apparently in response to changes in expectations about short term interest rate differentials - may limit expectations of easing, at least from a sentiment perspective.”
The other factor is the euro, which slipped to 107.5 to the dollar. But the way Davidson sees it, “a fall of 5, 6 or 7% is nothing new and is not particularly surprising. It is clear the euro capital market has taken off and European equity markets have strong backing. So the currency is accepted as a viable alternative to the dollar.”
Richard Newell is a director of Forsyth Partners.