When is a recovery not a recovery? When one of your closest allies and the world’s second largest economic power recovers from a recession. Say what? Hear out the logic based on data from Natixis economic research. Today, Natixis argued in a note that a US recovery could actually harm the Euro Zone.
Natixis sees the most favorable trajectory for long-term interest rates in the United States is a normalization, gradually bringing them towards 4% at the end of 2014. Long-term interest rates in the euro zone (the core euro zone countries) ought to remain very low if they reacted merely to the euro zone’s economic situation, but they are correlated with US interest rates, even though this correlation may become less pronounced. The rise in long-term interest rates on low-risk sovereign bonds will bring investors back to these bonds at the expense of riskier assets (peripheral bonds, equities, credit, bank bonds), leading to a repricing of the risk on these assets. This is very bad news for the euro zone, where, despite the persistent weakness of the economy, the economy’s funding costs will increase sharply, due to the rise both in risk-free interest rates and in risk premia.
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The US economic recovery is now, paradoxically, probably bad news for the euro zone
The consensus view is that the US economic recovery is good news for the euro zone, and will help it exit the crisis. This is by no means obvious:
The US economic recovery is “domestic”: it generates no additional imports, so it does not drive growth in the euro zone;
It leads to a rise in long-term interest rates in the United States and, if the correlation between US interest rates and euro-zone rates persists, will cause a rise in the euro zone’s long-term interest rates to a level unsustainable for the euro-zone economy.
Normally, US growth drives growth in the euro zone
In the past, growth recoveries in the United States have stimulated activity in the euro zone and contributed to a pickup in growth in the euro zone. From 1980 to 2013, US recoveries precede euro zone recoveries (by one to two quarters on average).
At present, however, the economic recovery in the United States may not benefit the euro zone, quite the contrary.
Two reasons which explain why the US economic recovery could now be a bad thing for the euro zone
1. The “domestic” nature of the US recovery The US economic recovery is above all driven by:
- The recovery in residential construction;
- Job creations in domestic services; and
- Not by manufacturing activity or productive investment.
2. Rise in long-term interest rates
The anticipation of economic recovery in the United States and the monetary policy response to the economic recovery led to a fairly rapid rise, in the second quarter of 2013, in long-term interest rates in the United States and, by correlation, in interest rates in the euro zone. The rise in long-term interest rates in the United States is not a threat for the US economy, given the expected growth level. If the correlation between long-term interest rates in the United States and long-term interest rates in the euro zone persists, on the other hand, the resulting rise in euro-zone long-term interest rates will be unsustainable for the zone due to the weakness of growth.
Conclusion: A euro zone depression due to the US recovery?
- If the US recovery, due to its domestic nature, does not lead to a pickup in euro-zone exports to the United States; and
- If it leads to a rise in long-term interest rates in the euro zone well above euro-zone growth due to their correlation with US interest rates; then it will amplify the weakness of the European economy, especially via the interest-rate-sensitive components of demand.