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Thursday, October 4, 2007

ECB Review and Preview

by Edward Hugh: Barcelona

Well the ECB is scheduled to have its regular meeting in Frankfurt this morning so Jean Claude Trichet will finally have to face the cameras and pronounce. Claus will have a longer analytical review of the situation here by tomorrow (he already has an initial "state of play" post on his blog), so this will be an extended note basically providing some background charts and data.

Perhaps a good place to start would be with this quote from Wolfgang Munchau's recent Financial Times article which Claus incorporates in his post:

(...) I see relatively limited room for manoeuvre. The ECB’s official short-term interest rates will probably stay at 4 per cent for a considerable period. The ECB will not start to cut interest rates until inflationary pressures subside, and until there is some hard statistical evidence of an economic downturn. At present, this evidence is confined to sentiment surveys.

Now Munchau is probably right in the sense that the ECB has boxed itself in in a way which effectively leaves it very little room for manoeuvre (Bernanke and King in their different ways have found room for manoeuvre, but the ECB is the ECB), but I think he is not right in asserting that the only evidence we have to date of a slowdown in the eurozone economies comes from the sentiment indexes. There is increasing evidence from the world of the real economy which we may also look at.

But first of all, let's look at one part of the underlying problem, the level of effective interest rates now operating in the eurozone. As can be seen from the following chart of the 3 month euro Libor (London inter-bank overnight rates), these suddenly shot up in August, well above the ECBs target 4% rate, and they stubbornly show no sign of coming down.

So this is the background problem, the European banks are nervous about lending to each other, and this is going to make obtaining finance for all kinds of needs much more difficult.

The German Economy

OK. I mentioned data, so lets look at some of it. Firstly Germany.

Well as Munchau says, we do have sentiment indexes. The ZEW insititute, for instance:

or the IFO:

Then German consumer confidence also fell - in this case to the lowest level in five months - according to the GfK AG's confidence index for October. The index fell to 6.8 from 7.4 in September.

But as I say, there are real indicators. First off quarterly German growth since Q1 2006:

As can be seen the German economy has now been slowing since Q4 2006, and if we treat Q4 2006 (due to the pre VAT rise burst in activity) as something of an anomaly, then we can see a steady decline since Q2 2006. In the present global environment my opinion is that this trend is unlikely to be reversed.

There are other indicators, like retail sales, for example. Here's a chart of the monthly index for German retail sales since January 2006:

But perhaps most shocking piece of real data to come out of Germany is the decrease in the rate of expansion in German services revealed by the latest Royal Bank of Scotland Services PMI, which dropped from a level of 59.8 in August to one of 53.1 in September. Since services have played such an important part in the recent German boom this slowdown is deeply significant.


The Italian economy has "recession bound" written all over it. Firstly the Q2 2007 GDP already revealed a sharp slowdown:

On the sentiment side, consumer confidence in fact recovered slightly this month from recent declines:

But Italian business confidence fell to its lowest in almost two years in September. The Isae Institute's business confidence index fell to 92.2 from a revised 93.8 the last month.

And of course Italian retail sales dropped in September at the steepest rate in more than two years as economic growth visibly slows.

A seasonally adjusted index of retail sales was at 44.1 in September, its seventh consecutive contraction, compared with 47.8 in August, according to a survey of 440 retail executives compiled for Bloomberg LP by NTC Economics Ltd. The reading has stayed below 50, the level that signals a contraction in sales, since February.

Here's the retail PMI chart, and remember, any reading under 50 means contraction.

And of course there is services. In fact European service industries grew at the weakest pace in two years in September. The Royal Bank of Scotland Group revealed yesterday that its European services index fell to 54.2, the lowest since August 2005, from 58 in August.

Italian services hit a level of 53.9:

Spain and Greece

However, maybe it should come as no great surprise that the German and Italian economies are slowing. What is going to be new - at least in post EMU terms - about this slowdown is the fact that some of the formerly "stellar" economies in the eurozone - Spain, Ireland, Greece - will also slow, especially due to their dependence on the construction sector, and indeed they may well slow faster and further than all the rest.

Early indications of this are already coming out of Spain. If we look at the rate of mortgaging and the value of new mortgages we can see, although the most recent data we have at this point for July, signs of the beginning of a slowdown are everywhere. We can get some idea by looking first at the number of mortgages contracted each month.

Also we have the value of these mortgages in millions of euro.

Now the data we really need are the figures for September, but this means we won't really know the full extent of the initial hit on Spain till early December. Nonetheless some indication can be obtained by looking at what was happening before things seized up.

What we can see is that the property market in Spain really peaked towards the end of 2006. The market hit a bottom in April, but there was a rebound in May (offers from property promotors?). But the rebound was not sustained and then the market again resumed the downward march. All we need to know now is the extent of the damage in September, and how low can we go. I am not optimistic. This is with us for some timne to come, and will probably be - proportionately - much more important that what is happening now in the United States.

If we now move on to the sentiment indexes, we have a first data reading in the shape of the Spanish Consumer Confidence Index. Over to Bloomberg:

Consumer confidence in Spain declined to a record low in September after the fallout from the U.S. subprime-mortgage slump pushed up borrowing costs worldwide.

The Official Credit Institute's index of consumer sentiment dropped to 80.2 from 86.5 in August, the institute said today on its Web site. That is the lowest reading in a series that started in 2004.

The cost of inter-bank loans jumped in August after European lenders disclosed losses in the U.S. mortgage market. That pushed up payments for Spanish homeowners who have variable-rate loans tied to the 12-month interbank lending rate for the euro region.

``Spain is heading for a marked slowdown and by mid-2008 we expect it to be growing at decidedly below-trend rates,'' Dominic Bryant, an economist at BNP Paribas SA in London, said in an e-mailed note.

The 12-month Euribor rate jumped to 72 basis points above the European Central Bank's benchmark interest rate this month, twice the average spread since the debut of the euro. In Spain, 95 percent of home loans have variable interest rates.

Here's the chart:

and here's the chart for the sub-components:

What can be seen from this chart is that all the components reached a peak this summer in April and May, in June and July they were all down, but only to the level of February/March, then from July onwards the whole thing starts to subside, and who knows if we have touched bottom yet, since all the forward indicators are a bit more positive, but my feeling is that that is rather an indication of the fact that people still don't appreciate the gravity of what is happening. It hasn't sunk in yet, and people are still expecting the housing market to pick up in a quite unexpected fashion. Spain could face a hard landing. If things continue to move at this speed it will get one.

Also service activity in Spain, which accounts for some 60 percent of the economy, posted its slowest expansion in almost two years in September, according to a separate survey of executives by NTC economics. The index fell to 52.4 from 53.5 in August.

A similar picture can be seen in the manufacturing PMI, although manufacturing accounts for a much smaller part of total economic activity in Spain than in some other European economies.

In the case of manufacturing, the rate of expansion has been slowing since June, although some reduction of activity is normal in the summer. It is the September reading which should give cause for concern here.

At the present time we are simply talking about a slowdown in the rate of expansion, but how far is this now away from an actual contraction. Not very, I would say.

If we now, finally take a look at what we know about Greece, we could say that the answer is not very much. I can't find a consumer confidence index for Greece, and Bloomberg do not publish any PMIs. So Greece is a bit of a "dark zone" as far as data goes, and this isn't helped any by the lengthy delays exhibited by the Greek Statistical Office when it comes to official data releases. In general terms, as far as anything interesting goes, we are back in June or July at this point.

We do however have data on new building permits. The latest data we have is from June. Looking at the chart, the slowdown from the middle of last year is clear enough.

The year on year growth graph also says it all I think.

We don't have too many other measures for Greece at this point, but the Greek Statistical Office do use cement output as a proxy for the level of construction, and a glass at the volumes used does tell its own story.

Even though in June and July there was a recovery from the lower level of earlier in the year (when remember the government deficit reduction was affecting civil engineering projects and the interest rate tightening at the ECB new home starts), the level is way down across the board from a year earlier, as can be seen clearly from the year on year chart.

And remember all of this is pre the sub-prime turbulence in August, since the latest month we have any kind of data here for in July.


Well, despite the fact that we still have a long way to go before we get a full appreciation of the extent of the slowdown across the eurozone, I beg to suggest that at this point we have considerably more to look at than "mere" sentiment indexes.

So why, in the face of all this negative data won't the ECB turn tail today and start reducing rates, as for example the French administration and a growing voice within the European manufacturing industry community are requesting. Well as Wolfgang Munchau suggests they have boxed themselves in rather (and unfortunately Trichet is neither as adroit, nor as willing to face the music at this stage as Bernanke and King have proven to be).

DailyFx's Kathy Lien puts her finger on just the part where it hurts most I think:

Despite the European Central Bank’s reluctance to acknowledge the impact that a 1.43 Euro has on economy, the damage can already be seen. Earlier this week we had softer inflation and weaker confidence reports. Today German retail sales dropped 1.4 percent despite the fact that unemployment hit a 14 year low. Unsurprisingly, confidence in the region as a whole also deteriorated. The EU’s Junker has already said that the strong Euro is starting to be a great concern for the group. It seems to be only a matter of time before ECB President Trichet makes a similar comment. Why has the ECB been so stubborn? Today’s 2.1 percent flash estimate of consumer prices is a good reason. This is the first time in over a year that inflation has rose above their 2 percent target. Even though the rising Euro is suppose to reduce inflationary pressures, the even stronger rise in commodity prices is offsetting that impact. The ECB has a monetary policy meeting next week. Interest rates are not expected to be changed, but as usual keep an eye on the comments that ECB President Trichet makes at the accompanying press conference. He is definitely not expected to bring back the words strong vigilance, but at the same time, he may not be able avoid making cautionary or dovish comments particularly since many banks have been borrowing at the ECB’s penalty rate indicating that the credit markets have far from stabilized.