Economic data released over the last few weeks depicted a positive picture for the Eurozone economy. The most positive indication came from Q4 GDP: it rose by 0.5% q/q and 1.8% q/q. In 2016, the Euro one economy rise by 1.7%, higher than the 1.6% posted by the US economy. It was the first time since 2008 that Euro zone economy overperformed the US one.
The first data for 2017 confirmed the positive momentum for the Euro zone economy. The most positive indication came from business and consumer confidence indices. For example, the European Commission Economic sentiment index rose in January to 107.9, the highest since March 2011. According to our estimates, the index is at a value in line with a 0.7% real GDP growth in Q2.
PMI manufacturing indices for January remained well above 50, signaling that the positive trend for the manufacturing sector over the next 2/3 months.
In a medium term perspective, the rebound of monetary aggregates in December signaled that economic activity could continue growing at solid pace in mid-2017. The M1 growth rate rose from 8.5% to 8.8% and M3 from by 4.8% to 5%.
The strength of the economy in late 2016 and the solid perspectives in early 2017 led economists to revise upward their estimates on 2017 GDP growth. According to the consensus gathered by Bloomberg in January, the Eurozone GDP should rise of by 1.5% in 2017. In December, the consensus expected an expansion in 2017 of 1.4% and in November of 1.3%. We expect economists to further revise upward their estimates if the recent positive trend would continue over the next few months.
In this scenario, some investors think that the ECB could end the asset purchase program before the expiration in December.
The recent increase of inflation strengthened this view: in January, the CPI rose 1.8% y/y. We expect the March revision of ECB staff projections on Real GDP and Inflation to see an increase of CPI estimate - in December inflation was estimated to rise by 1.3% in the current year and by 1.5% and 1.7% in 2018 and 2019 respectively. However, we think that the revision will be contained and will not force the ECB to change its monetary policy. We think that, with CPI core at 0.9% y/y, the ECB should consider the recent increase of inflation as transitory.
Despite the positive economic outlook, the government bond markets provided signs of caution. While the recent increase of government bond yields is a sign that investors believe in a recovery of the Euro zone economy, we see the recent increase spread between the Italian and French 10 years government bond yields against the German one as a source of concern.
Over the last week, the spread between Italian and German 10 years government bond yields rose to 183 basis points, the highest since March 2014, and the spread between French and German 10 years government bond yields rose to 62 basis points, the highest since January 2014. The spread between Italian and Spanish 10 years government bond yields also rose to 60 basis point, since February 2012. In June 2016, the Spanish 10 year bond had a higher yield than the Italian one for the political crisis.
We think that political uncertainties are the main reasons behind the increase of both Italian and the French government bonds yields. In Italy, early elections are more likely after the Constitutional Court decision on the electoral law. The dispute with the European Commission on the budget law is a further source on concern. In France, the race to presidential elections of 23 April and 7 May become more uncertain after the eruption of the scandal involving the favorite candidate of the moderate right Fillon.
With political tensions expected to continue for some time, in our view the government bond yields could remain under pressure in the coming weeks. With rising CPI favoring an increase of German Government bond yields, we hardly see a decline for both the Italian and French government bond yields, even if a slight narrowing of spreads seems possible.
Rising government bond yields could also have negative consequences on the equity market. Indeed, since 1990 the average monthly performance of the DJ Stoxx was 0.7% when yields were at a lower level than the year before and zero otherwise. While all the major euro area stock indices are in an upward trend and the main trend indicators suggest that this trend will continue, we think that the performance could be negatively affected by the rise in yields, especially in those countries were the government bond yields spreads is widening.
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