Great Graphic: Bunds and the Euro

There are two separate by related developments that are lifting the euro to its best level in three-months against the US dollar.   

First, the US economy is off to a disappointing start to Q2 after the economy appears to have contracted by around 1% annualized pace in Q1. The strong bounce back after the contraction in Q1 14 has thus far not materialized.   

The unemployment rate may be falling faster than the Federal Reserve had anticipated.  This has been the case since almost the start of the recovery.  However, the FOMC will likely find itself in the difficult position of having to downgrade its growth forecasts for the year at its June update.  The central tendency of Fed's forecast was for growth to be 2.5% this year.   

For the sake of the argument, let's assume that the contraction in Q1 is offset in full by the recovery in Q2.  That means that the economy would need to grow by 5% in the second half to achieve the Fed's forecast. The US grew by an average (annualized) quarterly pace of 4.8% in Q2 and Q3 last year.  That was the fastest since H2 03.    The risk is that the Fed's forecast for this year is revised below 2%.  This may leave it in a better position to raise its forecast at the September meeting, for which we still have not been persuaded that April data rules out lift-off in four months.  

One of the questions this raises is about the underlying growth rate of the US economy.   Fed Chair Yellen noted that with lower growth forecasts announced in March that the Fed was still expecting the economy to grow above trend.  Among other things, this means that the slack in the labor market would continue to be absorbed.   

Trend growth is determined by two variables.  The growth of the workforce and its productivity. Both are notoriously difficult to measure.  Demographic shifts typically are the driver of the growth of the workforce.  Many economists assume around 1% annual growth in the workforce. Productivity is considerably more difficult to measure, especially in the service sector.   

The government's data shows that over the last five years, productivity growth has averaged about 0.7%. Over the last three years, the average has been 0.6%.   This simple exercise warns that trend growth may be 1.5%-1.7%.  Ironically, the faster improvement in the labor market than the Fed had expected has weighed on productivity growth.  

The second key development has been the dramatic rise in German bund yields.  The spark may have been signs that the deflation threat had eased.  The dramatic rally in European bonds was partly a function of anticipated (and then real) ECB buying, but it was also a function of anticipation that deeper deflation pressures would emerge.  The extensive market positioning fanned the spark into a flame that burned the bond bulls globally.  

The lack of liquidity may have helped exacerbate the move.  By "lack of liquidity"   we mean conditions in which small transactions can have a disproportionate impact on prices.  This ought not to be confused with volume.  The diminished liquidity is arguably a function of QE and financial institutions adopting to the new regulatory environment, 

This Great Graphic, composed on Bloomberg, shows three time series.  The white line shows the premium the US offers over Germany on 10-year bonds.  It peaked at 190 bp on March 11.  The green line is the euro.  It bottomed on March 16 near $1.0460.   The yellow line is the yield of the 10-year German bund.  It bottomed on April 17 just below 5 bp.   While maybe the initial recovery in the euro was spurred by shift in market sentiment around the March 18 FOMC statement and forecasts, the more recent fuel appears to have been the rise in German yields.  

This suggests that until bunds stabilize, the euro recovery may persist.  Today the German bund yield returned to last week's high near 77 bp.  The yield had fallen toward 50 bp at the start of the week.  Whatever improvement in the technical indicators that this fostered has now been reversed. There is no compelling technical evidence that the high water mark for the German 10-year yield is in place.