Europe's Growth: The Trade and Brexit Factors

Mid Week Bond Update

Europe's Growth: The Trade and Brexit Factors

Uncertainties related to trade in general – and Brexit in particular – are already impacting Eurozone economies.


Europe's Growth: The Trade and Brexit Factors

While many in the UK wonder what the political turmoil over Brexit could mean for their economy, there’s also much at stake for the Eurozone.

Europe's economic health rests, at least in part, on the frictionless trade environment currently enjoyed within the 28-country European Union as well as between the EU and the rest of the world. A Brexit-generated disruption of trade between the UK and the EU could resonate for years in the form of reduced trade, sluggish economic growth and financial market uncertainty.

Already, economic growth and overall business conditions have seen better days and don't appear to be trending upward, as this Western Asset chart shows. Quarter-over-quarter GDP growth has been trending downward over the past two years, falling from 0.8% in Q4 2016 to as low as 0.1% for Q4 2018; Q1 2019 came in at 0.2%. Composite PMI is also trending downward, falling from January 2018's strong 58.8 to a barely-growing 51.3.

With Eurozone growth on the downswing, any additional disruption from policy errors or botched negotiations could be an appreciable risk.

For insights on the potential impact of Brexit and trade on Europe: 
Western Asset's Mike Buchanan: Trusting Our Convictions
 

Eurozone Impacted by Trade and Brexit

Chart courtesy of Western Asset. Source: Bloomberg, as of 3/29/2019.  This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
 

On the rise: Market-based U.S. estimates of a rate cut

Since the beginning of March, and especially after the Fed went "full dovish" at its March 20th meeting, the futures market for Fed Funds has traded as if the odds for a rate cut are greater than 50%.  In fact, the probability of a rate cut by the December 2019 Fed meeting has risen to as high as 78%. That suggests that the recent calls for a Fed rate cut by the White House and its recent nominee to the Federal Reserve Board of Governors could be in line with trends already in progress in financial markets.
 

On the slide: German Yields – Negative Again

Yields on the German 10 year "bund", Europe's key market benchmark, has continued to fall, reaching lows not seen since Q4 2017. Bunds now yield -0.05%, having moved into negative territory on March 22. The five-year now trades at -0.45%, with the yield last rising above zero in May 2018.

These rates might not be completely surprising, since the European Central Bank (ECB) is now "offering" a rate for deposits from banks of -0.40%. In effect, banks are required to pay for the privilege of leaving funds on deposit.

The ECB's negative deposit rates have been blamed by some for the financial weakness of Europe's banks, potentially putting Europe's economic situation in a vicious circle.  The difficulty of moving away from the current rate regime could be inferred from one novel proposal to break the logjam: moving suddenly to a positive deposit rate, which would have the benefit of helping banks generate positive profits from conventional lines of business.  That said, how to manage the sudden transition to positive rates without generating disruptive side-effects from sudden price movements in related assets is as yet unknown.

 


All data Source: Bloomberg as of April 2, 2019 unless otherwise specified.

Definitions:

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Markit Eurozone Composite PMI is based on original survey data collected from a representative panel of around 5,000 manufacturing and services firms. National manufacturing data are included for Germany, France, Italy, Spain, the Netherlands, Austria, the Republic of Ireland and Greece. National services data are included for Germany, France, Italy, Spain and the Republic of Ireland.

Bunds” refers to bonds issued by Germany's federal government. Bunds are available in 10- and 30-year maturities.

The federal funds rate (fed funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.

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