Market Opinion
Interest Rates
Euro Rates Rising
Euroland real GDP will grow by less than 1.5% this year, consumer sentiment in the largest economies is weak, and unemployment is high. Yet, the next move by the ECB – which may not be for a while yet – is very likely to be a hike in the benchmark refinancing rate. In fairness to the central bank, inflation is on the rise.
Indeed, the Eurostat September HICP Flash estimate rose by 2.5% y-o-y, up from 2.2% in August, and well above the ECB’s target of 2.2%. In addition, euro area money growth is showing the fastest rate of increase in 2 years, with August M3 up by 8.1%, versus expectations of 7.9%, with bank loans to the private sector rising by 8.5% y-o-y from 8.3% the previous month. The M3 figure is of course closely watched by the ECB, and this latest jump together with the rise in inflation data will no doubt harden the hawkish rhetoric emanating from central bank council members. Once the increase in money supply begins to revitalise domestic demand or investment, the ECB will act.
In fact, economic conditions in the region have shown an improvement over recent weeks. Industrial sentiment improved marginally from –8 in August to -7 in September, with exporter confidence increasing to –17 last month from –18 in August. Service sector confidence also rebounded to +11 from +9 in August. The recent IFO number is another example. Although most of the results were received before the election, the rise in the index to 96.0, its highest level since January, indicates that economic conditions may be turning. Again this set of data gives further weight to the argument that interest rate risks are skewed to the upside. That said, given the still slow pace of growth, we do not see a hike this year.
Even so, the market has started to take the ECB’s somewhat cautious stance more seriously. The June 2006 euribor contract dropped by 10 points last week to close at 97.58, implying a three-month interest rate of 2.42%. In fact, the contract has fallen by around 20 points over the past month. Although, much of the move is due to the decline in eurodollar futures, the market is realising that the ECB is growing more concerned by its accommodative monetary policy. The market could even be underestimating the ECB’s desire to up rates.
So are we now bearish euribor? It’s definitely looking that way. The drop through key trendline support in the 97.68-70 area for the June 2006 contract early last week was a clear warning signal. The subsequent end of week close below 97.60 indicates that this market is heading lower over the coming months. Nothing moves in a straight line, and any retracement – which is possible if upcoming data in the US is weak due to the Katrina effect – will meet resistance at 97.67 and 97.72. However, we anticipate further medium-term declines towards the 97.25-30 area in the first instance.
As for the bund, our suggestions on September 4 that the future contract was in overbought territory has been borne out, with the December contract falling from around 123.50 to its current level of 122.65. However, as we stressed at the time, the correction is somewhat short-term in nature, for two reasons. Firstly, we do not think euro rates are going to rise in an aggressive fashion, but far more moderately due to lower growth dynamics. In fact, they may simply adjust marginally higher. Secondly, we are less bearish the long end than the short end of the curve. Demand for bond yields will remain strong from the pension fund industry, which should cushion any major fall in prices. For the moment, though, the correction could well persist towards the 121.80-122.00 area over coming weeks, especially if US Treasuries remain under pressure.
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