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Thaler's Corner: European Bonds and Equities still at the mercy of Chinese Stimulus

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economy_1· Deflation picks up steam in Europe

July PPI, published this morning: -8.50% y-o-y.

This anticipated decline (-8.4%) stemmed from a major base effect, since commodity prices peaked in July 2008 when oil hit $146 per barrel.

That does not change the fact that this is the steepest decline for the statistic since it began publication. Even during the oil crisis of 1985, following a 67% oil price decline in four month, PPI contracted by just -4%.

We can look forward to a slackening in the decline of production prices in the coming months, which goes in the direction of the ECB’s “religious” denial of deflationary pressure on the eurozone. Would this validate the steep slope of short-term interest rate futures?

However, it is worth noting that monetary authorities have softened their message considerably as of late. As such, markets are beginning to price in lower short-term interest rates for a longer time period.

One of our big favourites, the Dec10 Euribor, climbed to 65 cents in August. It thus anticipates only a 2% Euribor 3-month rate at the end of next year, which I think is still a little too high.

 

Three conditions need to be met for the ECB to engage a restrictive monetary process next year.

The first and most important for the ECB is that, instead of deflation rearing its ugly head, real fears of inflation rising to above the ECB’s comfort zone of 1.80% to 2.00% take shape.

We think we are a long way from such a scenario, because, as you can see in the graph below, the deflationist impact on production prices is not limited to energy products.

If we excluded the building sector, which has been deeply distressed in the past year, and energy prices, the decline in PPI prices still comes to -4.05% y-o-y, compared to +4.30%, i.e. the biggest decline in this statistic ever, the previous record being -1.2% in 1999.

And the CPI, which has just fallen to -0.10% y-o-y excluding tobacco (EU 25), will continue to feel the pressure of this trend for some time, especially since consumers really seem to have grown accustomed to buying only discounted or subsidised goods.

 

The second condition entails the European banking system returning to health and re-building a sufficiently solid capital base in the eyes of regulators.

The security of the European financial system is one of the ECB’s responsibilities and recent statements by Chancellor Merkel and President Sarkozy show that a higher ratio of equity-to-assets is a priority.

So what better way for eurozone banks to re-build equity than to surf on the slope of the interest rate curve?

All they have to do is borrow short-term unlimited amounts of funds from the central bank at 1%, or obtain them directly on the interbank market (Eonia at 0.25%) and, then, invest them directly on a more or less long term basis, according to their risk appetite, directly into government debt securities (no haircuts at the ECB) or in the paper of banks who benefit from the explicit support of member-states.

This is one of the reasons that the short-term cash paper market has completely dried up in the past three month, given the impact of the LTRO.

And the third condition is that the economy and, especially, the jobs market, really picks up, even if the ECB does not have a double mandate like the Fed.

Given the latest statements by central bank bosses in Europe, they do not seem nearly as optimistic about this matter as stock indices, fuelled by liquidity injections and low short-term interest rates.

Or opinion on this matter were reinforced by certain precise statements by Bank of Austria President Nowotny, who must have caused his colleague , Iron-Man Stark, to fall off his chair while causing his compatriots, Privatdozent Ludwig Von Mises and Friedrich Hayek, turn over in their graves

This is the way he put it:

 

TOO EARLY TO DECLARE END OF FINANCIAL CRISIS

FIGHTING UNEMPLOYMENT MUST BE A PRIORITY

NO W-SHAPED RECESSION IF NO PREMATURE EXIT STRATEGY

 

His message is pretty clear: no early exit from today’s unorthodox monetary policy to avoid pushing the economy back into a recession, with interest rates remaining low for quite some time.

Eurozone PPI, CPI and CRB

Will commodities change the situation?

ecppi

  • Why China counts?

 

We see in the graph that commodity prices have a fundamental influence on the behaviour of the PPI and, thus, of the CPI.

We see the same type of curve in oil prices as with the CRB, which I did not post it here for reasons of readability.

Commodity prices plunged after the summer of 2008 (CRB -52%, Oil -78%), but then shot back up, like all risky assets: since February/March +22% for the CRB and 131% for the price per barrel.

We know the importance that the ECB accorded only recently to commodity prices, which led them to making their historic error of July 2008.

As it turns out, one of the reasons for this rebound in commodity prices is strategic stock-piling in China in the first half of the year, with speculation fuelled by loan injections into the Chinese economy. The examples of Chinese peasant stock-piling zinc and the purchases of ETFs by investors disenchanted with the prevailing official messages speak volumes.

As usual in this type of scenario, the bursting of the bubble should start from initial demand – i.e. strategic stock-piling – pulling the other investor categories in its wake.

Recent statements by Chinese officials about overcapacities (steel, cement, glass) -- as seen in the results of glass-makers around the world and by warnings from banks chiefs in China that loan volumes in H2 will be much lower than in H1 – lead us to believe that commodity prices are also in for a correction.

This will give the ECB the ease of mind its needs to maintain the status quo.

Watch out, however, as Chinese officials seem to be playing down their recent “hawkish” comment and try to limit price declines on the Shanghai stock index.

 

  • And Debt Deflation continues …

I keep returning to this phenomenon, which exploded onto the economic scene with the implosion of the Bear Stearns hedge funds. We can see it via the money supply figures and household lending on the eurozone last week (Thaler's Corner 27-08-09: What risks are keeping central bankers up at night?).

We saw another example yesterday, with the announcement by the Bank of England that British households, for the first time since the publication of this statistic, reduced their outstanding debt in July, despite low nominal interest rates.

This is normal behaviour, given high real interest rates, past and future unemployment rates and the tightening of loan terms by lending institutions.

 

We find ourselves in the classic situation described by George Bernard Shaw:  lower labour costs y-o-y after adjustments for efficiency gains!

This will not help aggregate demand, excluding subsidised purchasing (cash for clunkers, first-time homebuyers, etc.).

But it will comfort the FED in its decision to maintain short-term interest rates low for an “extended” time period.

Not real surprise in Japan, where Bank of Japan Governor, Kiyohiuko Nishimura, again confirmed the priority of fighting against the recession in the face of persistent deflationist pressure (CPI -2.2%).

The yen’s recent appreciation won’t help matters either.

We therefore still advise our clients to avoid stock markets and favour government fixed-rate instruments, while remaining vigilant, as they have climbed a lot lately.

 

Erwan Mahé - Otcexgroup

Asset allocation and option strategy

 




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