The Week End Blog – Holy Spirits, Market Turmoil and NAIRU

Suddenly, turmoil reached the markets this week. The main cause, Banco Espirito de Sanco, or more accurate, its parent company Espirito Sanco International, which missed a payment on its short term debt. This sent a shiver down the spine of the Portuguese and European financial sector. It is summer again, and summer and European financial markets have not been good friends in recent years.

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Other parties, that have ties with Banco Espirito de Sanco, were hit to. The shareholder overview of the bank, taken from its website, revealed some interesting names, with Portugal Telecom being the most pronounced. I would not have guessed a telecom company to be a big stakeholder in a holding company of a bank.

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The news of bank issues also pushed up the yield on Portuguese government bonds. In a couple of days the 10-year yield increased by a half percent. But do not forget that at the beginning of the year, when nobody ever heard of Banco Espirito de Sanco, the yield on the 10-year bond was 6%. Anyway, it is pretty difficult to imagine a situation where the bank of the ‘holy spirit’ will fail.

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Europe was home to more bad news. Industrial production numbers were miserable everywhere, even in Germany. But, as has been the case in recent months, France was again one of the poorest performers. The macro economic outlook in Europe has deteriorated of late. Not good!

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On the back of the disappointing macro data, the German 10-year government bond yield sought new lows. At one point this week the yield dipped to 1.17%, awfully close to the lows seen during the European debt crises. Based on a simple regression model, using the ZEW expectations index, the core CPI level and the 3-month interest rate, the yield should be way above 2%. That is of course, if there was no Mr. Draghi.

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Despite the weak data from Europe, Japan delivered the biggest surprise with the machine orders data. Notoriously volatile, yes, but a realized number of -14% (YoY) with +10% expected is pretty awkward. Poor macro numbers have opened the discussion on more QE by the Bank of Japan. So far, the yen has not mirrored that discussion.

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In the US the discussion focuses on the strong employment numbers of last week. The Fed minutes showed that the end of QE will come in October, provided everything works out as expected. A very interesting insight is that the US employment rate now matches the NAIRU, the non-accelerating inflation rate of unemployment. Thus, more employment will now lead to more inflation, theoretically of course.

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The notion that US employment is now nearing levels where wage growth and inflation could pick up is slowly reflected in the markets. Based on the Fed futures the first rate hike is expected somewhere around the middle of next year. Short-term interest rates are moving up.

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Higher US short-term interest rates could also turn out the be an inflection point for the euro. In my blog this week I argue that, in the near future, the two factors that have dominated the EUR/USD exchange rate, the relative size of the Fed balance sheet against that of the ECB and the difference in short-term interest rates, could join forces again, driving the euro down. Click here for the blog post.

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Finally, I think the markets had to cope with one more a bad issue this week. Netherlands crashed out of the World Cup, which I expect to have had a ripple effect throughout the world. At least in my world…

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