Rates on the move
After such voluble hints from European Central Bank (ECB) President Trichet himself, the first Euro-zone rate hike since October 2000 ought to have come as no surprise to the markets. Whether or not any move was necessary is less clear, however, and investors are not convinced that after this move, the ECB is ready to embark on a series of tightening moves.
Johannes Müller, euro fixed income portfolio manager at DWS Investments argues: “The fundamentals imply that a monetary tightening was not absolutely necessary, and inflation is not out of control. However, if we look at the monetary aggregates, or private credit growth, and house prices in certain areas like Spain and France, then it becomes fairly clear that Europe no longer needs rates to be quite so low; 2% is an emergency level, reached during summer 2003 when the whole world was discussing deflation. Though the Euro-zone economy is not booming, the outlook is no longer so bleak as to warrant those emergency-level interest rates.”
Sebastian Paris-Horvitz, head of investment strategy at AXA Investment Managers, says: “We do not see inflation coming into Europe. Consequently we have fairly mild expectations of what the ECB will do over the course of 2006. We agree that there may be inflation scares, perhaps driven by base effects stemming from the oil price rises, but we do not perceive significant inflation risks. While the Euro-zone economy is gradually improving, and the labour market is getting better too, it remains weak. Our argument is that the ECB will not want to go too far because the economy does not need it: all forecasts for GDP growth next year point to growth rates below the Euro-zone’s trend level.”
Mueller suggests that the market is perhaps a little aggressive in its forecasting of future rate hikes. “At one point the market was looking for the ECB to have tightened 100 basis points, including the 1 December move, by the end of 2006. Now it has come back a bit from those levels, which probably represented more of a risk premium issue rather than a rate rise prediction, but we still think that the ECB will not tighten as much as the market currently believes. In terms of economic fundamentals, we believe that 2006 will turn out to be much like 2005, and to that extent we think that the market has actually priced in far too much positive news in terms of the business cycle.”
Others think that the ECB will be adopting a ‘wait-and-see’ approach to future monetary policy.
Antonio Ruggeri, portfolio manager at Milan-based Sanpaolo Institutional AM says he thinks the ECB may well tighten again at the end of the first quarter of next year, but after that will be re-assessing the conditions. “We believe that the ECB will get to 2.5% (on the Refi rate) and then they will look to the economic statistics to see further indications of growth, and whether the third quarter GDP expansion rate has been sustained for example, before embarking on further tightening. Our forecast is that the economy will not be speeding up from the current rates, but we too will be watching the statistics closely to make sure.
“Although we have seen internal demand increase in both France and Germany,” continues Ruggeri, “a big factor driving European growth is external demand. If the dollar declines against the euro and we enter another period of strong euro, then this could hamper growth in the Euro-zone, and we might already have seen the peak in growth rates back in Q3 2005.”
That inflation will not come back to haunt the Euro-zone is a common theme in investor forecasts. “We do not think that it (inflation) is a big issue for the ECB,” says Ruggeri. “We think that the headline rate will trend down to the core rate, taking the gap down to zero. The situation in the US is different. There we think that the Fed Funds could be raised to 4.5%, with the chance that it could reach 5% if the Federal Reserve seeks to deflate the housing bubble.” Müller adds that the unions have no reason to push for higher wages and that second round effects, emanating from the higher energy prices, will probably not happen.
Although their 2006 central forecast is below trend growth in the Euro-zone, Ruggeri and his team acknowledge there is a risk that their forecasts could underestimate future growth for the Euro-zone. Ruggeri explains: “We could be wrong about the strength of the economy and, though this is not our central forecast, 2006 growth could come out greater than 2%. What if inflation did reappear, if the core measure moved up to headline? For us, the risk is skewed for higher rather than lower yields than we currently forecast.”
Paris-Horvitz adds that the oil price remains one of the big risks to AXA IM’s fairly benign scenarios, but also cautions that assuming the structural pressures on inflation will stay down may also be a risk. “We all recognise that globalisation and competition has put significant downward pressure on prices and that we have subdued inflation everywhere. But we have to consider the risk that in the US, for example, the labour market could come under pressure and inflation could well re-appear there.”
Mueller, on the other hand, argues that the risks are actually skewed the other way and that the economy may well be weaker than forecast. “Growth has been picking up but, as we know, it has been driven by external demand and private consumption has not and will not be a driver. The consumer is nervous, which is understandable. In times of stagnation of disposable incomes, as neither employment nor wages are set to rise, the savings rate is unlikely to fall significantly and so private consumption also stagnates.”
In Japan the 10-year Japanese government bond (JGB) yields lower than 2% and three-month money at around 0.1%, the Japanese Yen under some pressure on the foreign exchanges, bickering between the Bank of Japan (BoJ) and the Prime Minister about whether now is the best time to switch out of easing mode, the attractions of the Japanese bond market are not easy to fathom. For many investors that combination of factors makes it one of the ‘no-brainers’ to be underweight Japan, and perhaps very underweight, for their global government bond portfolios.
The Nikkei 225 has been rising and is now nudging the 15,000 level suggesting that the economy really is showing signs of sustainable growth. The signs that Japan’s deflation scourge may be disappearing, with nationwide core CPI finally reaching zero year-on-year in October, is perhaps the most notable ingredient for investors and policy makers alike. However, it is this data which has sparked a rather public row between the BoJ and Koizumi, when the BoJ suggested that it may be time to raise rates.
Graham Taylor of GFC Economics says: “The governor (of the BoJ) got hawkish after the October CPI figure and the government immediately jumped in to pressure the BoJ to delay any move to higher rates. Koizumi’s line is that this is the time to give the economy a chance and let the government do something about the fiscal situation.” Turner actually suggests that the BoJ’s target (for inflation) may well be flawed and that the focus should be on asset values and not consumer prices.
“Koizumi won a huge political victory in the election and is now in the unprecedented position of strength within the LDP, which has always been a consensus-driven, committee-led party. He is in a very strong position to carry out the huge fiscal and structural reforms needed to rid the economy of its massive public debt burden, and has been coming down very toughly on fellow ministers at any perceived weakness of resolve or action.”
So by attacking the BoJ when it suggests that quantitative easing should be ended, the government is effectively forcing JGB yields to remain low, says Turner. He adds that he is not suggesting JGBs are an outright buy, but he does say that investors should be wary about being too underweight just now.