Europe’s playing chicken with looming recession

Philip Salter
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THE markets’ are once more weighing up the Eurozone. Yesterday, the euro fell against all major currencies upon the growing suspicion that Jean-Claude Trichet is becoming dovish, together with the release of bad data. In the European Commission’s business and consumer confidence survey, the broad economic sentiment indicator (ESI) for August came in at 98.3, down from 103.0, against broad expectations of around 101.0.

Many commentators think Trichet is going soft, picking up on his comment during Monday’s testimony to the EU that “risks to the medium-term outlook for price developments are under study.” However, despite this hint “at a more dovish approach”, Kathleen Brooks of doesn’t “expect a sharp reverse-turn in the ECB’s thinking.” She says a cut in rates would damage the ECB’s credibility, particularly with real interest rates – adjusted for inflation – still negative. In any case, Trichet doesn’t need to cut rates to push low rates on the markets (see graph). As Simon Smith, chief economist at FxPro, points out: “In some senses, the ECB has already shifted its stance, given that the overnight rate has traded below 1 per cent through nearly all of August.” As such, “while the ECB has hiked rates twice, this has been far from fully reflected in markets, with 3-month overnight swap rates actually lower than was the case when the ECB first hiked back in April.”

Yesterday’s successful Italian bond auction will not be enough as Europe’s chickens come home to roost. Brooks describes Europe as “mired in trouble”, pointing to German lawmakers’ resistance to the legality of the extension of the European Financial Stability Facility (EFSF), Spain’s general election and “hefty” debt auction towards the end of this year, and continued wrangling over Finland’s collateral demands in return for lending to Greece.

Also, expectations for Eurozone growth are being cut. Jennifer McKeown, senior European economist at Capital Economics, says “the latest survey evidence suggests that the consensus forecast for Eurozone GDP to rise by 1.5 per cent next year is far too strong.” Adding, “even our own projection of a 0.5 per cent annual gain is starting to look slightly optimistic.” Crucially, Germany’s ESI dropped from 112.7 to 107.0. Given that so much hope rests upon the Eurozone’s largest economy, the sentiment of the German people is key to the continuation of their bankrolling of the single currency.

While the sun worshiping UK expatriate pensioners in the far-flung corners of Europe might be praying for a collapse in the value of the euro, so that they can make hay with their sterling denominated pensions, the value of their Spanish villas would plummet if converted back into the peseta. UK residents should also be worried, as it would signal a recession that would infect the UK. It’s impossible to know whether Europe’s leaders have the policy leavers to avoid recession, but even were a silver bullet to exist, they would at present lack a leader with the guts to pull the trigger.