On Wednesday, I had the opportunity to meet with Alain Duchateau, Deputy Director General of Economics and International Relations for the Bank of France. Banque de France is the Central Bank of France, and was founded in 1800. The Bank is located in the heart of Paris, about a five minute walk from the Louvre. With the creation of the Euro, the European Central Bank (ECB) is the Central Bank for the Eurozone, and the Bank of France is part of the European System of Central Banks.
Mr. Duchateau is a prominent figure in the European central banking community. His areas of expertise include business conditions and macroeconomic forecasting along with monetary and financial analysis. There are few people in France that would have a better perspective on monetary policy and economic conditions.
Some key takeaways:
Europe is beginning to recover, and the fears of deflation are dissipating. The fact that European bond yields have rebounded sharply from generational lows is a positive thing. This rebound can be explained from both a technical and fundamental perspective.
A weak Euro has been a significant factor in Europe’s rebound. Policy makers will be very concerned if the Euro rebounds.
The outcome surrounding the Greek crisis is uncertain. It is important to differentiate between economic and political risks. Economic risks to the financial system are relatively contained, but there is significant risk of political contagion. If Greece is rewarded for opposing “Europe,” then other countries that have undertaken painful reforms may be threatened and request similar concessions. This political contagion then leads to economic and financial contagion.
I have included some of the highlights from my meeting notes below:
The concerns surrounding Greece are taking too much energy. The European economy is recovering, with good Q1 figures reported for Germany and even for Spain. Spain has regained some of its competitiveness, and it is an example for other leaders in working with Europe. This is a formula of the Troika (European Commission, European Central Bank, and the International Monetary Fund) that has worked. Greece has become a political fight. The Greek election results in January that brought the left-wing government into power has required different negotiations.
Europe is back in positive territory, and Europe is out of the big fears of deflation. Europe still faces significant challenges with unemployment. Also, corporations seem more willing to buy back stock than to invest. Demographics are adding to economic challenges. The 30-50 year old age group is declining, and this age group is a big buyer of mortgages. It also doesn’t help that some government policies favor renters over buyers.
We discussed the sharp move higher in European government bond yields over the past two months. The “QE” measures announced and implemented by Mario Draghi and the European Central Bank were recognized as a strong commitment and were very credible in the eyes of the market. However, the buying accelerated too much, and may have become overdone and excessive.
The Central Bank welcomes this rebound—this is a positive thing. The underlying supply of bonds was shrinking too much, creating a limited supply. This was a concern. Interest rates at zero (or even negative rates) were creating worries for insurers and for banks. A low rate environment is pressing margins—the guaranteed rates offered by these institutions was worrisome. The rebound in rates can also be explained from a purely technical perspective, and French government bond yields have moved back to a more normal spread of 40-45 basis points over German Bunds. The move in rates also makes sense from a macroeconomic standpoint—the economy is improving and the fear of deflation is fading.
The driver of the rebound in the economy has been a weak Euro. While the Euro has rebounded in recent weeks, this has been mostly due to the recovery in rates. The spread of 2 year government bonds is what drives the currency, and this highlights that there is less reason for the Euro to continue its rebound. German Chancellor Merkel recently voiced concern over the recent rebound in the Euro. This is unusual for a German leader to be talking down the Euro, and is a sign of a “compassion move” for Southern European countries.
The disparity of unemployment across the Eurozone continues to be large. German unemployment is between 4-5%, France has 10% unemployment, and some Southern European countries have unemployment north of 20%. While labor mobility is not the same as in the U.S., difference in economic conditions have caused population movements within Europe. For example, Germany’s strength is leading to in-migration from across Europe. Differences will remain, as labor harmonization across Europe will be restrained.
Because of the Monetary Union, competitive currency devaluations are not possible. An increase in competitiveness can only come from increases in efficiency and productivity. France faces the challenge of how to exit from a minimum wage that is too high. It is noteworthy that France’s Socialist government is thinking about this—it is no longer taboo to discuss. France’s retirement scheme is changing—it is no longer the late entry to the work force and early exit from the workforce.
The conversation came back to the current crisis with Greece. In order to understand the issues, we need to differentiate between the economic and the political consequences. Greek’s debt is now in public hands—this is one of the criticisms of the 2011 agreement with Greece—that the banks did not take enough of a hit. In the current crisis, there is no need to fear a domino effect from European banks. The banks simply do not have too much exposure. The public’s exposure is high, but governments have the ability to spread the pain. Remember the term “extend and pretend” when it comes to negotiations with Greece.
The real risk of Greece is political. Many European countries have seen the rise of populist parties, and the consequence of the negotiations with Greece will have a profound impact. It is worrisome that a country can be in open conflict with “Europe,” and extract gains from this opposition. This threatens politicians and political parties that have forced painful reforms. Their populations may question why these politicians agreed to painful concessions. European policy makers want to provide positive incentives for those that have made efforts to reform. Will Greece survive in the Euro—you never know…The most likely outcome is that a compromise is reached, but it will come to the last minute. There is even a feeling of Greek crisis fatigue in Germany, and there is an increasing feeling that Greece should be let go.
Germany and France remain united on the diplomatic front, particularly on Ukraine. They are united against Russian aggression. They are less united on the economic front. Germany advocates balanced budgets, while France has a 4% deficit. Things are different for France in reaching an economic equilibrium. The French government won’t derail a recovery by tightening the budget.
We talked about “too big to fail” in the aftermath of the 2008 crisis. The question of “too big to fail” surrounding French banks is no longer a French question, but is now a European question. It is no longer the case that bond holders will be completely protected at the expense of the taxpayer. This will introduce more discipline.
It was a fascinating conversation with Mr. Duchateau, and the time went too quickly. I came away impressed that European policy makers are very aware of financial markets. It also confirmed one of our basic premises—Central Banks continue to rule the world.
Special thanks to Brennan Staheli, Michael Willden, and the Lunt Capital team for their contributions to this report.