20. January 2020, 15:16 Uhr
Pressure is rising on many European governments – and above all the particularly thrifty German one – to make use of rock-bottom interest rates and open their coffers to invest in creaking public infrastructure. Not least the ECB itself, but also the IMF and numerous think tanks clamour for fiscal spending, not only in order to raise government investment: First, by issuing more sovereign debt, governments would provide insurers and pension trusts in need of safe assets with longed-for government bonds which, particularly in the case of Germany, have become extremely short in supply, thanks to the ECB’s massive buying. And second, by virtue of this additional issuing of bonds as well as increasing investment demand, yields and hence rates would begin to climb eventually – a rare incident of classic textbook economics (if there was such a thing as crowding-out, nowadays it’d be positively welcome, for firms have mutated into net savers). And it’s especially in the case of Germany that the times of forced balanced budgets are about to end – If the grand coalition collapses, even sooner than later at that. Other penny-pinching governments such as that of the Netherlands, too, have sent tentative signals that they might be inclined to raise public spending financed by debt in order to fend off an economic malaise in the Euro Area, thanks to a deep manufacturing recession triggered by global protectionism. Taken together, that’s why we expect yields in the Eurozone to rise materially over the course of this year, creating upheaval on financial markets in due course (though, outside of a veritable melt up in yields, not in respect of the euro exchange rate, see below).
Were inflation to take off this year, the upward pressure on yields would yet increase further, of course. But we do not anticipate inflation to stir – not over the course of the coming twelve months, anyway. Where should it come from? Energy prices? Highly unlikely: Only an all-out and prolonged war in the Middle East could provoke such a shock. Witness last year’s drone attack on Saudi oil installations: Within weeks production was back online, and prices quickly reverted to their levels before the attack. The US-Iranian stand-off at the beginning of this year followed the same script; and there’s oodles of US shale oil ready to fill the gap should Mideast producers really suffer lasting disruption. What else to trigger inflation? Wage pressure? Even less likely: With the exception of the UK, such pressure is nowhere to be discerned. The US labour market evidently still has much slack to go before wages start to be bid up; the Fed has acknowledged as much during its ‘listening’ tours through the country just recently. And in the Euro Area, many countries’ labour markets are showing signs of decreasing employment growth already – above all Germany. Excess demand? If anything, the Eurozone suffers from the contrary, while the US appears far from overheating. So inflation will not rear its head as soon as this year. If it were to, yields would lift-off even more than anticipated by us, in turn rendering our analysis only the more valid.
With regard to forex markets and in relation to the general expectation of yields staying low, the majority of analysts anticipate a weaker US dollar over the course of this year, too. In our view, those colleagues focus too much on yield differentials (admittedly shrinking of late) between the US and the rest of the world while underrating the considerable upside potential of the greenback in case of further geopolitical tensions and/or a reignition of the Sino-American trade spat. By the same token, if there were no such idiosyncratic risks materialising, a healthy US economy then would not have the Fed cutting rates again, lowering the prospect of a further reduction in the yield differential between the buck and other currencies. Either way, we fail to see the rationale for a weaker US dollar in 2020, and anticipate the balance of risks to be much more tilted in favour of a strong greenback. If, ultimately, US yields were to rise in tandem with others as described above, such a scenario would be even more likely.
By contrast, we don’t see much upside potential for the euro, even though its trending yet lower should be limited by rising yields as anticipated above. The deck is stacked all against the European common currency, with Brexit still threatening to harm an already weak Euro Area, Italy still lowering to create yet more political risk, and the ECB nowhere near a substantial recalibration of its ultra-dovish policy. Only massive fiscal spending way and beyond the expectations of markets and in excess of what we have described above were to let yields spike and the euro to lift off, for then two effects would kick in simultaneously: First, loads of European sovereign debt prominently among those trillions of negative yielding fixed income would turn positive enough to attract loads of money in search of safe returns (which, however, would kip a lid on yields rising even further). And second, after the common currency has been used as a funding currency in carry-trades against higher-yielding forex, those trades had to be closed in a rush, giving the euro a mighty push. This scenario is not out of the question, mind; but for it to happen, all major Eurozone economies had to engage in heavy deficit spending simultaneously – not a very likely prospect, then.
Addendum as of 2 September: With the Fed’s having adopted average inflation targeting (AIT), we expect our projection of rising yields to turn out yet more relevant. A mere fiscal spending push counterbalanced by the expectation of rates rising in response doesn’t help much to lift inflation. Yet now, the Fed has explicitly vowed not to do so, thus yields ought to rise even further than anticipated by us originally.