The rise in long term bond yields comes at a good time for the euro area

We always thought that the ECB will probably not have to go all the way 4.5% or even higher because the required monetary tightening would come from other sources. We thought the euro’s exchange rate would break the ECB’s need for short-term rate hikes, as a rapid rise in the Euro would lead to an uncomfortable tightening in monetary conditions. We still think there are risks for the dollar/euro rate that stem from a yet underestimated effect of the US housing recession, which has a long way to go, and which has not yet affected the US consumer – to our surprise, we admit – but we believe that the US consumer cannot withstand a sustained housing recession forever. The risk of a euro/dollar overshooting $1.40 at some point this year remains plausible in our view – not based on any trendline analysis – but on the probably that at some stage the euro area will look very strong relative to the US.

 

The rise in long-term bond yields is the other factor that puts the pressure off the ECB. The yield curve is steepening again, and in our view the correction in the long end is far from over. We agree with analysts who have been forecasting 10yr US treasuries yield of 5.5/6%, with European yields also pushing well above the 5%. This is in some respects the most benign form of monetary tightening, since the rise in the short-end, much responsible for consumer and mortgage loans, has already had its desired effect on household credit, while the rise in the long end will ultimately take care of the business side.

 

The rise in long-term bond yields will also do wonders for M3 growth, which as the ECB has rightly noted in its latest monthly bulletin, has been heavily distorted by speculative inflows from abroad. A steeper yield curve will have investors pulling out of M3-assets into the longer end, bringing M3 growth down to more sustainable levels. While in fairness the ECB’s second pillar – the monetary pillar – is not a primitive M3 watch, but a detailed analysis of monetary conditions and credit conditions in the euro area, the fall in the headline rate in M3 is still important in the sense that it gives the ECB a narrative, if one were needed, why the pace of monetary tightening can slow down. 

 

Over time, the return to a normal yield curve, which we firmly expect, will also take the froth out of the credit market. This could happen in a benign way, or in the form of some severely financial turbulence, but either way, an eventual return to more normal credit market spreads will be an additional monetary dampener.

 

Our view is not that further monetary tigthening is not needed, or not desirable, or not necessary, but rather that it will come in the form other developments – through the exchange rate, through credit spreads, and higher bond yields. That still does not rule out the possibility that the ECB may have to rise interest rates beyond 4.25% this year, or next. That may well happen if new inflationary signals were to arise – beyond those we already know about. Another important factor, of which we know too little, are the extent and impact of capacity constraints in the euro area industry. If some of the anecdotal reports we hearing are representative, the euro area may already be suffering from serious capacity constraints in selected sectors. For now, we believe that inflationary pressures in the euro area are benign, both in absolute terms, and relative to previous cycles. In short, there developments may well arise that could persuade the ECB to raise interest beyond what we expect. The future is no less uncertain today than it was in the past. But at the same, we expect that bond and credit markets will do some if not most of the work.

 

There, not at the short end, is where we expect the real action to be.

 

 

Eurointelligence ECB Watch

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