The level of risk aversion that emerges from many indicators seems at odds with a scenario, for some, full of uncertainties. Basically, judging by their level, there seems to be no tension in the markets regarding the possibility of an internationalization of the Syrian conflict or a resurgence of the euro crisis. The recent behavior of these indicators confirms that financial markets are once again in “risk on” mode. This in itself could be a selling factor for peripheral country bonds as the odds of seeing a temporary setback may have been underestimated.
Indeed, the macro scenario in the G7 countries seemed, just a few weeks ago, full of uncertainties. The growth prospects of emerging countries seemed less bright than expected, particularly in China. After the release of some high-frequency data this mood was reversed. The Fed's tapering is fairly unanimously seen as another source of volatility, while the ECB does not seem to have much room to maneuver to absorb any negative shocks. Despite this backdrop, risk aversion indices showed steep declines across a broad range of financial assets. While some market players are counting on a new wave of volatility and an increase in risk aversion, our forecasts instead underlie a period of low risk premia.
The macroeconomic prospects for the Euro area describe a scenario of moderate growth in the second half of the year, helped by the recovery of its main trading partners. The United States is showing growing signs of strength in domestic demand, thanks to a stable recovery in the labor market. After a few months of decline in productive activity, China seems to be oriented towards a recovery rooted not only in foreign demand, but also in domestic markets. The recovery of the eurozone, although in full swing, is still suffering from the crisis of its peripheral members. Even in the hardest-hit countries, however, there are some green shoots of recovery.
With output gaps still wide there are few signs of inflation in the Eurozone, but also in the US. Considering the lagging nature of the unemployment rate over the economic cycle, the output gap will take time to narrow, putting downward pressure on inflation dynamics in the coming months.
Fiscal policies in the peripheral countries of the euro area are oriented towards further consolidation, but with a greater focus on growth issues. Structural deficits will mark important improvements on the issue of fiscal sustainability. The public debt expansion trajectories should forecast a headway between 2013 and 2014.
The Italian political situation. In recent weeks we have witnessed a modest increase in the BTP-Bund spread and a clear underperformance compared to Spanish bonds now trading at levels of yield comparable to those in Italy. Since the early stages of the euro crisis risk aversion indicators have increased their correlation with Italian political events, considering their current level the vast majority of these indicators would suggest that the chances of a new political crisis in Italy are rather negligible and/or that budget balances will remain in line with the targets of the stability pact even without a strong government at the helm.
While early elections seem less likely today, we are more skeptical about the ability to meet the deficit targets espoused in the stability program for 2013 (-2,9%). As we have recently documented (IRS 11 September), despite the reassuring words of Finance Minister Saccomanni, achieving the objectives set for the current fiscal year will be challenging. The need to devise a new set of growth-friendly austerity measures to compensate for a likely overshoot could be a strong argument against the hardliners. That said, even if President Napolitano is unable to avoid a new round of general elections, we do not think political instability in Italy will jeopardize the broader trend of global stabilization of financial markets.
Euro. In general, we believe that the euro area has now overcome the crisis of confidence that has hit the single currency. While there are still major challenges to address the new economic and fiscal policy governance framework, the creation of a financial rescue mechanism and the conferral of supervisory power over the banking system to the ECB have radically changed the playing field. Furthermore, setting up a European resolution mechanism for troubled banks will complete the structure of the banking union and further contribute to the financial stability of the EMU.
The Fed. Another potential source of volatility is represented by the Fed's monetary policy. Will the Fed be able to manage the exit strategy without shocks to the financial markets and the economy? Judging by the inertia with which it initiated the tapering, it seems that the Board intends to greatly dilute its restrictive value. As the Fed partially confirmed in its September meeting communiqué, there are at least three main reasons that should keep the Fed extremely cautious. First, yields have risen very significantly since the Fed started signaling the possibility of tapering reaching levels close to long-term values. The second reason relates to the inflation outlook. There are no signs of a build-up in inflationary pressures. Core indicators are still below the Fed's target, input inflation is still low and unit labor costs do not indicate cost pressures. The output gap is still very large and does not exert inflationary pressure on the demand side. Finally, inflation expectations are well anchored at levels consistent with the Fed's inflation mandate. The third reason concerns the resilience of the recovery in the face of rising interest rates. This is largely an open question, but judging by the recent behavior of consumer confidence indices, it would be risky to go too far with an aggressive exit strategy.
Overall, there are many reasons to believe that the Fed will try to pull itself out of QE3 in order to avoid market backlash. One way to do this is to work on the communication channel and clarify the nature of the “7% level” for the unemployment rate which has been widely interpreted as a trigger to stop QE3.
The ECB. The most effective policy decisions concerning the ECB concerned the communication strategy and the extension of its institutional role to also include the supervisory role of the banking sector. With the latter we have not yet arrived at a banking union, but we have at least come close to it. It is also an important step towards the creation of a single resolution mechanism for the banking sector and the direct involvement of the ESM in the possible process of recapitalization of banks in the euro area. The new supervisory architecture should help reduce risk premia on the interbank market, easing the dependence of banks in peripheral countries on ECB funding and improving the effectiveness of monetary policy transmission channels. On the communication strategy there is a clear tendency of the ECB to consider further expansive interventions, while the commitment to keep low rates has been extended. Putting aside the rhetoric of the ECB, the room for maneuver for conventional interventions has practically run out: there is still the possibility of another 25 bp cut, but this would be the last one anyway. With no room for further cuts, the ECB would have to re-engage unconventional measures if warranted by deteriorating economic and market conditions. The ECB's toolbox on the matter appears much less varied and comprehensive than the Fed's and another LTRO would be the most likely option.
In short, we don't expect too much from the ECB. The easing cycle should have already reached its peak. A final marginal intervention is still possible and should be implemented as soon as possible to increase the chances of recovery. This decision should also be facilitated by the fact that the Bundesbank is certainly very happy with the new power of the ECB in matters of supervision and a marginal cut in the refi would in any case decrease the probability of unconventional policies. The progress recorded on the interbank market should allow for a more uniform effect of monetary policy and this should also be transmitted to the credit conditions of the peripheral countries affected by the crisis.
To conclude
The level of risk aversion emerging from many indicators seems at odds with a scenario of an extension of the Syrian conflict or another wave of euro crisis. Setting aside the Syria-related geo-political risk, we believe we have entered a period of low risk premia. An overall positive macro outlook, monetary policies with a still expansionary bias in the United States and the Eurozone and the strengthening of economic and fiscal governance in the EMU should herald a period of more stable market conditions.
