Euro area bond yields to riseBy Miranda XafaGreater European indebtedness and the simple rules of supply and demand, in particular excess supply, will be major factors in driving up eurozone government bond yields during the next two years and are factors that are still largely not priced into the yield curve.
Theoretically, bond yields in the eurozone should decline in line with lower inflationary expectations. The European Central Bank (ECB) is predicting that inflation will fall below 2% in the coming months and remain subdued.
However, lower growth in the three largest eurozone economies – Germany, France and Italy – has left their governments unable to balance the books. Their only recourse is to issue more debt.
And the eurozone safety mechanism, the Stability & Growth Pact (S&GP), is not working properly. Under the pact, eurozone governments agree not to let their public expenditure rise above 3% of GDP. Germany and France broke the ceiling last year and will do so again this year. Italy, too, has used a series of one-off measures to stay below the limit but could well breach the 3% level next year.
To date, Germany and France have been placed by the European Commission under the so-called “excessive deficit procedure”, which could make them liable to a fine – as much as 0.2% of each nation’s GDP – for breaching the S&GP. Rather than pay a fine, early indications from Brussels suggest that the S&GP will be renegotiated, leading again to higher eurozone debt levels.
ECB strategy could lead to lower ratesBy Allan SaundersonECB officials do not want people to conclude that the changes in monetary strategy they announced after the May meeting will lead to lower interest rates sooner. But they probably will.
The thrust of the comments by ECB board member Otmar Issing was that little has changed after an eight-month strategy review. In fact, the changes are a complete overhaul, tantamount almost to a reversal of the strategy that the ECB has used until now. Effectively, the inflation target has been changed. The ‘two-pillar strategy’ has been reversed to give money measurement a subordinate priority. The definition of price stability has been changed to correspond more closely to the reality of deflationary developments.
The annual review of the M3 reference value will be abolished. Still, there is no indication that the ECB has adequately altered the strategy to take into account the risks associated with the current rise in the external currency value.
This all implies a more accommodative stance in the future from the ECB, with economic growth and activity more strongly factored into interest rate deliberations and the outdated focus on money retreating into the wings.
Yet because this is precisely the conclusion that officials do not want the markets to reach – and was explicitly denied – the ECB discussion to date has largely been taken at face value. After all, a further cut in European official short rates would take them to levels not seen in the past 50 years on the continent. Eurozone interest rates may fall more quickly than the Euribor rate curve has factored in.
This means that the rather alarming rise in the euro against the dollar should begin to be checked. On a longer-term view, ECB support for eurozone economies, rather than attempting to quash the demon of inflation at every turn, will boost GDP growth and hence is euro-positive.
Changes in the ECB strategy have come from two directions. Internally, the hand of ECB vice-president Lucas Papademos can be seen supplying board-level support to a broader approach to monetary analysis than the rather simplistic view of money supply targets. Externally, the pressures to change have come from the almost universal criticism from academics and official bodies. Almost all supranational institutions have been in intense and growing disagreement with the ECB’s strategy, and therefore its stance – most notably the European Commission and the Bank for International Settlements.
Spanish political risk on the riseBy Mike HallsThere is a growing likelihood that Spain’s centre-right Partido Popular (PP) will fare badly in next spring’s general election. In its place, a coalition government between the left wing PSOE and regional parties, particularly the Catalan regional party, CiU, could take office.
If this were to happen, the present balanced budget of the PP would be replaced with a fiscally looser one, with greater public spending on social programmes and greater state involvement in business. Further labour and pension reforms would be curtailed.
Spanish prime minister José María Aznar (PP) is doing badly in opinion polls with his main contestant, José Luis Rodríguez Zapatero (PSOE), as much as six percentage points ahead. This is the worst Mr Aznar has polled since he was re-elected in March 2000.
The prime reason is Mr Aznar’s support for the US war in Iraq. Given that opposition to military involvement at one point reached nine out of 10 adults, his present position behind his rival is as much a tribute to his ability to maintain support against unfavourable odds as Mr Zapatero’s inability to attract PP voters.
Given a speedy conclusion to the Iraq war and Spain’s still-positive economic background – the European Commission forecast on April 9 GDP growth of 2% this year and 3% next – Mr Aznar should recover some lost ground. The question the coming May elections will answer is: how many voters have been alienated on a long-term view?
Miranda Xafa is an independent economist based in Athens. Allan Saunderson, based in Frankfurt, is a European Central Bank watcher and chairman of Eurozone Advisors. Mike Halls is editor of Euro-Insider.