Eurozone Recession Spreads to Core Countries from Peripheral
The European Central Bank (ECB) recently lowered its economic forecast for the eurozone's 2013 gross domestic product (GDP) to a 0.3% contraction compared with the 0.5% growth estimate it forecast in September. The decrease was largely due to recent weakening in Germany and France, which together account for about half of the eurozone GDP.
Germany, which has long been the pillar of strength, recently lowered its 2012 GDP growth forecast to 0.7% from 1.0%, as GDP is expected to contract 0.3% in the fourth quarter. The country also lowered its 2013 forecast to 0.4% from its June estimate of 1.6% based on its assessment that GDP may also contract in the first quarter of 2013.
The ECB held its benchmark refinancing rate steady at 0.75% at its December meeting, but as the recession in the eurozone expands, we would not be surprised to see the ECB cut short-term rates.
As the troika supports beleaguered Greece, this action indicates that it would also support other countries that become financially troubled
While the economy across the eurozone is poised to contract further in the near term, Spanish and Italian bonds rallied in the fourth quarter. The yield on their respective 10-year bonds dropped 57 and 45 basis points to 5.37% and 4.64%, respectively. The market has priced in lower sovereign default risk and thus lower systemic risk. The ECB created the Outright Monetary Transactions (OMT) programme last fall, which will support nations that officially request financial assistance and accept a macroeconomic adjustment programme to be developed by the European Union in conjunction with the International Monetary Fund (IMF). In addition, sovereign investors have taken comfort in the continued support of Greece by the ECB, EU, and IMF. As the troika supports beleaguered Greece, this action indicates that it would also support other countries that become financially troubled and lose capital market access, thus lowering the probability of a near-term default by either Spain or Italy.
US Fed: If a Little Is Good, More Must Be Better
The US Federal Reserve announced last week it would purchase outright $45 billion of long-term Treasuries per month after Operation Twist ends. In addition, it eliminated the calendar date guidance on how long it anticipated keeping interest rates at zero. Instead, it replaced the calendar date with an unemployment target of 6.5% as long as one- to two-year inflation projections are below 2.5%.
Based on the Federal Open Market Committee's current projections, unemployment would decline to that level sometime in the first half of 2015. If the Fed were to purchase $45 billion of Treasuries and $40 billion of mortgage-backed securities through then, it will increase its holdings by approximately $2.5 trillion, nearly doubling the size of its current balance sheet.
The intent of the Fed is to support the housing market by reducing rates on mortgages. By doing this, the Fed believes its monetary policy will transmit into the broader economy as home affordability improves and homeowners refinance into lower-rate mortgages, freeing up disposable income. The Fed's premise is that as house prices stabilise and rise, banks will become more willing to extend credit and consumer sentiment will improve as household net worth increases. Considering the zero interest rate policy was launched in December 2008, that target would entail six and a half years of ZIRP. With inflation ranging from 1.5% to 2%, real interest rates are negative through the 10-year Treasury, resulting in considerable financial repression for savers.
One aspect of the FOMC's announcement that has been mostly overlooked is that the committee further reduced the midpoint of its expectations for real GDP growth. Since its January 2012 statement, real GDP growth expectations for 2012 have been reduced to 1.8% from 2.5%. For 2013 and 2014, the midpoints of its GDP growth projections has declined about 0.4 percentage points to 2.7% and 3.3%, respectively.
