Draghi modestly optimistic, but he also sees high risks

The Chart of the Week shows euro zone CPI inflation and the annual change in Brent oil prices in EUR/barrel. If tensions between the US and Iran remain or intensify and the euro depreciates further, CPI inflation figures will probably disappoint going forward. We don't think that this will affect the ECB's rate decisions as it will probably focus on disinflationary pressures stemming from economic weakness and the broken credit transmission mechanism.

United States

• As economic activity seems to expand at a decent pace in the short-term, one of the big questions is whether all the new money that has entered financial markets over the last few years due to gargantuan easing of central bank policies will finally make its entrance in the 'real' economy.
• In that respect it is interesting to note that consumer credit surged USD 20.4bn in November after USD 6.0bn in October. Nonetheless, a large part of the increase can be explained by student loan growth. Consequently, growth of consumer credit has remained modest so far and we expect it continue to stay relatively modest this year, but credit growth should increase somewhat based on an improvement in labour market conditions and signals that auto sales continue to pick-up.
• The velocity of M1 and M2 money stock has declined quite dramatically over the last few years, which implies that inflation is no concern as long as overall bank lending growth remains subdued. That said, bank lending is gradually increasing, but it is still expanding at a modest pace.
• Still, one could argue that the Fed should be cautious with its monetary policy actions given its aggressive policy over the last few years and possible inflationary risks if it overshoots. On the contrary, dovish Fed officials seem to remain in the majority as was signaled last week. Consequently, QE3 remains a possibility this year.

Euro zone

• Last Thursday was the first ECB meeting in which Draghi decided to keep the refi rate unchanged, at 1.00% after he cut rates by 25bps in the last two months. Meanwhile, financial market participants are speculating about further rate cuts below 1%. While there are multiple arguments to defend another rate cut by the ECB, we don't think that the central banks' policy makers are eager to lower rates below 1% in the short-term as lower rates will have only limited effect on economic activity in the current environment, in our view.
• Draghi was quite enthusiastic about the effects of the 3-year LTRO. As we discussed 2 weeks ago, basically all the money that has been borrowed from the ECB has been stalled at the ECB again (against 25bps). Draghi counter argued on a question in the Q&A that banks who borrowed from the ECB were not the same banks as those who deposited money with the ECB. Although the tender can likely at least partly explain why shorter-term government bond securities have outperformed longer-term debt the last few weeks, this seems unsustainable unless the ECB provides more amounts of cash or banks withdraw money from the deposit facility and start purchasing sovereign debt.
• As regards macroeconomic developments, economic conditions remain worrisome. industrial production fell 0.1% (mom) in November to -0.3% (yoy), which added to the evidence that the euro zone economy contracted in Q4 of last year. German industrial production figures showed that even activity in the best performing sector in the euro zone's largest and strongest economy is weakening.
• Although we are relatively optimistic about the German economy (we expect 0.6% growth on average), also the euro zone's largest economy will face multiple headwinds. In fact, even a recession seems within the realm of possibility. In addition, weak German growth may raise concerns about whether the northern countries are willing and able to support the periphery countries.
• At the end of the week, S&P announced a credit rating downgrade of nine euro zone countries, including that of France and Austria. This shouldn't have been a surprise to readers of the Markets Roundup. Although the rating downgrade doesn't need to have much impact, there is a risk of self-fulfilment (i.e. that interest rates of relatively weaker countries such as Italy and France will pick-up again to reflect their higher risk compared to other countries that have the same credit rating). In addition, there is a risk that also the EFSF will be downgraded.

United Kingdom

• The UK is not a safe haven in our view. Fiscal deficits are high, debt levels are rising quickly, the country has a current account deficit and the BoE is 'printing' money as fast as it can.
• Looking at current gilt yields, it becomes clear that not all investors seem to agree with us given that bond yields have plummeted to record lows over the last few years. Bond investors have increased their purchases of public debt over the last few years. Domestic, but also foreign investors continue to add gilts to their portfolio at a fast pace.
• This can be partly explained by the UK's 'safe haven' status, given that investors are making negative real returns, although demand for gilts has also been supported by the BoEs asset purchases. We don't expect the latter to end given our expectation for a new announcement on an increase in the Asset Purchase Facility of GBP 75bn next month. Indeed, the markets are always right, so to say, but the question is how long market participants believe that the UK is a safe haven.
• We are not alone in thinking that current yields are too low to compensate for the countries' risks (and inflation levels). Although only a small majority (51%) of the respondents in the Deloitte CFO survey said that gilts are overvalued, it is worrying to see that an increasing number of respondents who said that bonds are 'somewhat overvalued' say that bonds are 'very overvalued'.
• In our view, gilt yields may pick-up in two scenarios. The first scenario is when concerns about the euro zone sovereign debt crisis abate and risk appetite returns. As this is an unlikely scenario, we think that the second scenario is a more likely one. That is, yields may rise once concerns increase about the UK's fiscal and economic situation. So far, however, investors seem to remain confident with the UK's safe haven status, but we remain concerned about its economic and fiscal situation.

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