Behind the Curve?

[A couple of corrections and snippets have been added below] 

Last week, the most eye-catching jitter in financial markets was undoubtedly the EUR/USD's rally to above 1.50 a stance which it is still maintaining today trading around the 1.52 mark. Another event whose importance rather paradoxically can be ascribed to its status as 'non-event' was conjured in Russia where the puppeteer show of a presidential election produced the expected result as Dmitry Medvedev ascended to power. I could talk more about this but I won't since this is really not my area; a certain Mr. Lucas is of course all over this already. Rather I will move on to more familiar grounds in the context of the Eurozone economy, her central bank and the battle of wills between investors looking for a crack in the armor to gauge when, if at all, we will see interest rate cuts and the hawks who are keeping a watchful eye on the data to see whether their position can be maintained. The recent volley of data definitely seem to have bolstered the hawks' case if only a little bit in an environment where the incoming data had been almost persistently pointing to the downside. This in itself was what prompted Euro to move towards the skies last week and is a testament to the sensitivity of global liquidity to yield on the short end of the curve. Especially, data from Germany has been a pleasant surprise recently with a pick-up both in activity indicators measured, in this case, as business and consumer confidence readings as well as a steadily declining unemployment rate. As the icing on the cake the hawks also have the recent inflation and wage readings to point towards as they make their argument for why the ECB should not follow the Fed. 

Yet, and even though the market headlines these days persistently fields the breaking of new records of high and lows I was still quite amazed by a particular Bloomberg piece on the ECB's interest rate stance and outlook. At first glance there is nothing overtly exciting about it but following from the headline (Trichet Rate-Cut Resistance Empowered by Eastern Europe Trade) and on towards the main theme of the article we get this ...

Demand from eastern Europe ``buys the ECB time,'' says Andrew Bosomworth, a fund manager at Pacific Investment Management Co. in Munich. ``Growth is incredibly dynamic. The place is awash with money and booming.'' Sales to new member countries have more than doubled since 2000. Exports to Russia, which now sits on the European Union's eastern border, have almost tripled. By contrast, exports to the U.S. have expanded just 12 percent in the same period. The euro region now exports more to new EU members than to the U.S. Sales to Poland and Russia jumped 22 percent in November from a year earlier, and exports to the Czech Republic rose 18 percent. By contrast, sales to the U.S. fell 1 percent. The region's export boom is also cheering executives trying to shield their businesses from the U.S. slowdown.


Trade with eastern Europe is also helping the euro region's exporters cope with the currency's rally against the dollar in the past year. All of the EU's newcomers have pledged to switch to the euro at some stage, meaning their currencies move in closer tandem with the euro than the dollar.

This may of course be an editorial glitch and in that case I shall not rant extensively about it but at this point in time I don't think that the trade and credit links with Eastern Europe can be used as an argument for why the ECB is likely to stay on hold with respect to interest rates. Quite the opposite in fact. I am not going to roll out the argument here and regular readers will know very well what I am talking about in the context of Eastern Europe; see collection of AS notes here. I am thus inclined to make the exact opposite point as the one fielded in the article since it is indeed very true that the trade and credit link with Eastern Europe has been a very lucrative one. However, 'has been' is the key formulation here and we need to understand that all this is likely to come to an end now and the only thing we really need to gauge is the extent to which we will see a hard landing or a soft landing across Eastern Europe. Obviously, there are timing issues in all of this and some countries in Eastern Europe may even fair better than others. This is not really the point. The point is that narrating Eastern Europe as a mitigating factor for European economic conditions at this present juncture seems to be rather bold, border lining to un-informed I am sorry to say. Ok, rant over.

In any case we are best served by looking forward. And that is exactly what the ever readable Eric Chaney does in his most recent note over at Morgan Stanley's GEF (Feb. 28th edition). Chaney basically echoes the scepticism voiced at this space as to resilience of the Eurozone economy going forward. I am happy to note Chaney's mentioning of the asymmetry between the member countries which I personally think is an enduring feature of the Eurozone edifice and one which is bound to command more attention as we move along. Especially the divergence between Italy and Germany is striking ... 

On one side, German manufacturers continue to benefit from stronger demand than their neighbours.  We believe that it is the product specialisation of the German industry – the most competitive in the world for machinery and equipment and related capital goods – that makes it so resilient.  As already mentioned, the demand for capital goods that originated in fast-growing emerging markets such as China is structural, not cyclical.  Since demand seems to grow faster than production capacity in this particular sector, companies benefit from more pricing power than others, which also explains their lack of sensitivity to the strength of the euro.  In Italy’s case, the story is quite different. Output expectations have stood below their long-term mean for three consecutive months, while current production dropped below trend for the first time in 27 months.

The discrepancy between Italy and Germany seems to be all about exports and how Germany is much more adept in leveraging the global market place than is Italy. In fact, of course, this divergence goes along way back and I shall not dwell by it here but merely note that it is exactly in times such as these that the difference is most pronounced. Whether Germany can keep on pedalling this fast is an open question; I don't think so but as we have seen Germany definitely has the capacity to surprise. In general, Chaney turns his analysis towards microeconomic factors and notes that corporate capex/spending is likely to be revised down significantly as get deeper into 2008.

Looking forward, we still believe that the credit crisis, compounded by the stock market correction, is likely to hit corporate spending in the euro area this year. In this regard, the downward revision of production plans is good news, as it reduces the risk of a hard landing.  However, we cannot exclude such an outcome: we think that production expectations are still too optimistic with regard to the slowdown of actual production already under way, and to the gravity of the credit crisis.  Watch our Surprise Gap index in the next round of business surveys!

The uttering of a hard landing in the Eurozone is still a whee bit premature, even for my otherwise bearish inclinations. I concur with Chaney in the sense that if his main analysis is right, and thus if production plans/expectations are persistently out of sync with realities the ensuing correction could turn out quite severe. However, I think we need a bit more evidence before we call it as such.

Finally, in this mixed post of snippets on the European economy and economies writ large I picked up on the following in context of Hungary which, as you may remember, recently lifted the trading band on the HUF vis-a-vis the Euro.

The strong negative sentiment that hit Hungary's fixed-income market last Friday has not evaporated on Monday either, and yields rose further 15-20 basis points, following Friday's 30-60-bp leap. “Panic has engulfed the market," a market player, talking on condition of anonymity, told External market developments also contributed to the dour sentiment and there are signs of increased risk aversion all over the world. A rise in yields is further weakening the forint. The HUF is approaching 267 versus the euro, which marks the weakest level for the Hungarian currency in about two weeks.  

There are many potentially interesting points for discussion here not least the pressing preoccupation Hungarian authorities and companies must have with how to find buyers of HUF denominated debt in the current environment. The silver lining in all this is that after the removal of the trading band there is no lower limit for the Forint and this thus brings forth all kinds of risk scenarios which previously were not contemplated (at least not by the way we need to do now). The main issue here is without a doubt the bind Hungarian households and companies would found themselves in in the context of a persistent depreciation of the Forint as it would make the servicing of the large pool of debt mainly denominated in Euros Swiss Francs almost impossible. The following snippet is important in this context;

The sharp appreciation of the CHF Friday (EUR/CHF down by 1.9% and 6.2% below the Oct 2007 levels) may hit the Hungarian economy disproportionately given FX lending is almost entirely happening in CHF.

This is exactly the translation risk issues Edward and I have been talking about and now we will see how the correction plays out and whether it will have consequences for the real economy.