Europe is finally enjoying a recovery. But bond markets are in for a shock

Economic View

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The Independent Online

Mario Draghi is extraordinarily adept, and his pitch-perfect press conference was testimony to that. He stressed that the ECB’s stimulus programme would be carried through in its entirety, and that the European economic recovery would broaden and deepen: “The recovery is on track exactly according to our projections.”

So there. But this very model of a modern central banker has to work with what he has got, and what he has is a bond market that is convinced that long-term interest rates in Europe have only one way to go: up. Yields have headed relentlessly upwards since 17 April and went on climbing after Mr Draghi’s remarks. The euro, which has already had a few strong days, climbed too.

Since the aim, or at least one of the aims, of the ECB’s QE programme was to push down bond yields and the euro, you might think the markets are not listening. But while the 10-year Bund yield has gone from 0.05 per cent on 17 April to just under 0.9 per cent this week, we are a long way from US or UK 10-year yields of 2.3 per cent and 2.05 per cent respectively. You can, as some market commentators have done, call the recent climb in rates (and the corresponding collapse in values) a rout, but actually yields are still lower even now than they were last October, when the impact of the ECB plan began to seep through.

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Underpinning this rise in yields is a genuine recovery across much, not all, of the eurozone. You can catch that in a number of ways. The new ECB forecast suggested growth this year would be 1.5 per cent, against 1.3 per cent in February. It also upped its inflation forecast. But it is also helpful to look at what people do as well as what economists say. If you take a hard number such as car sales, for the first four months of this year they are up 8.2 per cent.

You can catch some feeling for the turnaround in the two graphs. Real household incomes are at last rising, though there is a lot of ground to be clawed back, and consumers say they are more confident. European consumers are a gloomy lot, reporting negative sentiment even during the boom years, but they are no longer in despair, as they were in 2009 and 2013. The key point here, I think, is that bottom was reached at the beginning of 2013, so the ECB by coming in late last year was reinforcing a recovery that had already got going of its own accord. This is classic central banking tactics: you don’t push against the markets, because you may lose: they are bigger than you are. But when you spot a turning point, that is the time to come in and give things a further push. You get the credit and burnish the image of central bankers as all-powerful actors on the economic stage. 

There are three questions now.

The first, and you cannot get away from this, is what will happen to Greece. But while this is massively important in human and political terms, I’m not sure it is important in economic terms. At less than 2 per cent of eurozone GDP, it is simply too small an economy to have more than a marginal impact on the rest of Europe. You cannot measure it, but I suspect that a default is already priced into the markets. It would certainly come as no surprise. German car buyers are not going to delay replacing their vehicles because Greece is failing to repay its debt to the IMF. At an investment level, there has similarly been no contagion from Greece, across to Spanish or even Italian bonds. If that judgement is right, the wider eurozone recovery will not be affected if Greece defaults, but correspondingly there is no upside if it manages to cobble together some deal that notionally avoids this outcome.

The second question is how secure the recovery is in the face of rising bond yields. My own view is that once a turning point is passed, it takes a lot to derail a recovery. Looking at that top graph we can surely say that a turning point is well past. Suppose the 10-year Bund yield goes to 2 per cent by this time next year, the level of the equivalent UK gilts now, will this wreck everything?

You have to be careful, because sudden market movements can lead to unforeseen consequences, but it is hard to see a rise in rates happening so swiftly as to undermine recovery. Besides, these ultra-low interest rates create distortions. Hans-Werner Sinn, president of the Ifo Institute in Munich, argues in a new paper that by inflating asset values and cutting income, the ECB’s policy risks having perverse effects. Pensioners are being particularly hard hit: “The ECB’s low interest rate policy increases the initial value of their assets, but lowers their ultimate value.”

At some stage there has to be an exit from QE and as yet we have no idea of the trajectory of that exit.

That leads to the third question: is there already a bubble? Goldman Sachs has just put out a paper arguing that European equities, while not particularly cheap, are not that out of line with long-term valuations. That seems fair enough. European property values, insofar as you can generalise, are also not that far away from long-term trends. So it is really only the bond market that is completely off the scale. US and UK markets are now returning towards some sort of sanity, though those of us who think the 30-year bear market in bonds has begun reckon they have a long way to go. But European bond yields, even with the recent pull-back, are still outrageously low. There is some sort of bubble and the challenge for Mr Draghi, if he is not to go down in history with the sort of tarnished reputation that many now attach to Alan Greenspan, will be to extract Europe from the consequences of his policies. Good news for the economy is bad news for the holders of bonds.

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