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Jefferies International Limited. European Economic Outlook 2013: A year to complete the European project and all change at the BoE?. David Owen Managing Director, Chief European Economist. January 2013 European Economics Team David Owen dowen@jefferies.com +44 (0) 207 898 7317
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Jefferies International Limited European Economic Outlook 2013: A year to complete the European project and all change at the BoE? David Owen Managing Director, Chief European Economist January 2013 European Economics Team David Owen dowen@jefferies.com +44 (0) 207 898 7317 Marchel Alexandrovich malexandrovich@jefferies.com +44 (0) 207 898 7344
Herding, biases, information asymmetries & bounded rationality Financial crisis between 2007 and 2009 and what happened following it, particularly in the euro area, should put paid to notions of strong market efficiency and general equilibrium. History tells us that it can take years to come through a financial crisis, that banking crisis always lead to sovereign problems and heightened risk of default both on public and private sector debt. Moreover, in the absence of positive supply shocks (think ICT in Scandinavia in the 1990s) trend growth following the crisis can be significantly lower than prior to the downturn. In macro terms it is important to give growth a chance (partly via a weaker exchange rate) and delay the necessary fiscal adjustment until the economy is stronger. Problems in the euro area have been compounded by the combination of fiscal and monetary tightening in much of the region, and no help from the exchange rate. Perceptions of weak or no growth can quickly become self-fulfilling. Negative feedback loops quickly developed between the sovereign and the banking sector in some countries, pushing the system into a very bad equilibrium with increasing concern of a break-up developing in 2012. Mario Draghi’s verbal intervention of last summer has reduced that tail risk (a commitment to use its unlimited balance sheet) but the system is still not in a good equilibrium – in particular, the system remains in recession. Moreover, the reaction function of the ECB remains very different to that of the Fed, the BoE, SNB, DNB and now BoJ, much less focus on the macro. There remains political risk and social unrest (especially with E17 unemployment heading towards 12.5% in 2013). Mario Draghi’s verbal intervention has certainly bought time, but there is a general expectation that there has to be a move to closer integration post the German elections.
Networks, tipping points and information cascades • Market participants segmented, even investors in the same asset class. Time frames short, reputational risk important, with investment decisions not always necessarily taken on investment grounds alone. • A story of imbalances. Part of the legacy of this period is the exposure still of the core to the periphery and to the wider euro area economy. This always significantly reduced the risk of a break-up (because of the implied cost to the core), but as soon as the crisis broke cross-boarder capital flows started to dry up. Hence the need for the SMP, the LTROs, TARGET-2 imbalances and now the promise of the OMT. • For many traditional long-only investors benchmarks matter, which means that rating action can quickly tip a sovereign over. If, for example, the rating agencies had downgraded Spain to below investment grade that could have quickly forced the Spanish sovereign to the bailout and activated the OMT, especially as the ECB and the rest of the Eurosystem was not intending buying the sort of duration of paper that long-only institutions typically hold. This is in contrast to when the Eurosystem was buying Greece as part of the SMP when that sovereign came out of the benchmarks in 2010. Then sellers were matched by buyers (Central Banks). Moreover, the scale of forced selling if Spain had come out of the benchmarks would have been much greater than that seen for Greece. • Rough rules of thumb can matter, with market participants anchoring. During the crisis certain prime numbers such as 5 and 7 appeared to take on a life of their own. • Now we are in a world where many investors are trying to gauge what might now be fair value for Spanish bond yields say over German bunds. The risk may have been reduced but there remains a probability of exit and inside/outside EMU the risk of default. Much depends on whether we see any signs of recovery by the middle of the year.
Mario Draghi, ECB’s press conference 6 September 2012 “What I said exactly is that – and I repeat what I said in London the first time – we will do whatever it takes within out mandate – to have a single monetary policy in the euro area, to maintain price stability in the euro area and to preserve the euro. And we say that the euro is irreversible. So unfounded fears of reversibility are just what they are: unfounded fears. And we think this falls squarely within our mandate. There are no ex-ante limits on the amount of Outright Monetary Transactions The present programme is very, very different from any other programme we had in the past. First of all, we have this conditionality element………The second one is that there is going to be much greater transparency: as I said before, we will publish the OMT holdings, the duration, the issuer, the market value. So there is going to be much more transparency. The third is that the duration is different. And the fourth is the explicit statement that we will accept paripassu treatment with the other creditors”
TARGET 2 Imbalances Source: NCBs and Jefferies
Level of GDP and cyclically adjusted budget deficit in Finland
Private sector indebtedness and loss of output since start of Great Recession
The ECB have told us they can do QE: It is all in the communication “Central banks are given a clear mandate, to achieve price stability, and the independence to achieve it through the instruments they consider most appropriate. I do not understand the quasi-religious discussions about quantitative easing. It is appropriate if economic conditions justify it, in particular in countries facing a liquidity trap that may lead to deflation. The instrument is implemented in the UK and US, where the central banks consider that there are risks of deflation and where the policy rate is constrained by the zero lower bound. This is currently not the case in the euro area because the ECB currently sees no risk of deflation. But if conditions changed and the need to further increase liquidity emerged, I would see no reason why such an instrument, tailor made for the specific characteristics of the euro area, should not be used.” Lorenzo Bini Smaghi, FT Interview 22 Dec 2011 (ECB Executive Board Member up until 1 Jan, 2012) And what of Mario Draghi’s interview in the FT on 18 Dec 2011?
The time frame of monetary policy “To maintain price stability over the medium term is the primary objective of the ECB’s monetary policy. The medium-term orientation reflects the fact that monetary policy cannot, and therefore should not attempt to fine-tune developments in prices or inflation over a few weeks or months. Moreover, the medium-term orientation makes it possible for monetary policy to take into account concerns about output fluctuations, without putting price stability at risk.” Mandate of the ECB “A target of 2% does not mean that inflation will be held at this rate constantly. That would be neither possible nor desirable. Interest rates would be changing all the time, and by large amounts, causing unnecessary uncertainty and volatility in the economy. Even then it would not be possible to keep inflation at 2% in each and every month. Instead, the MPC’s aim is to set interest rates so that inflation can be brought back to target within a reasonable time period without creating undue instability in the economy”. Mandate of the BoE
How the BoE justified QE under Article 123 of the Lisbon Treaty “The key point is that the Bank is not being forced to create money in order to cover the gap between the government’s tax income and spending commitments. If it were carried out to finance the budget deficit, it would be a violation of Article 123 of the Treaty on the Functioning of the European Union. Rather, the Bank is undertaking Quantitative Easing in order to meet the inflation target and will sell the government debt back to the private sector once the economy recovers, thus unwinding the original increase in the money supply.” Charlie Bean, Deputy Governor BoE “The purpose of the purchases was and is to inject money directly into the economy in order to boost nominal demand. Despite this different means of implementing monetary policy, the objective remained unchanged - to meet the inflation target of 2 per cent on the CPI measure of consumer prices. Without that extra spending in the economy, the MPC thought that inflation would be more likely in the medium term to undershoot the target.” From Quantitative Easing Explained, BoE
The inevitable outcome of the Fiscal Compact: how much would a Eurobond cost? Source: Jefferies International
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