The global downturn has now hit Europe with its full force. Today, not only PMIs fell across the euro-zone. Also the German ifo-index took a bad hit, experiencing the largest one-month-drop since the recession of 2001. Both the expectations as well as the current conditions index dropped sharply. The expectations component is now not far away from levels seen during the last recessions.
Suddenly, even the German economy does not look as resilient any more as it was long claimed by some observers (see my post here on false complacency concerning the strong euro). Nevertheless, Germany still looks strong compared to the rest of Europe: According to the PMI surveys, the German manufacturing sector is merely stagnating while the sector in most of the rest of Europe already is in recession.
The deterioration has come quite suddenly: Only in April it still looked as if Europe could dodge a recession even if the US economy would experience one. Now, the European economy looks even more vulnerable than the US where the manufacturing sector might be flirting with recession but according to the ISM survey is still growing marginally.
While it is certainly overdone to shift all the blame for this sharp downturn on this side of the Atlantic on the ECB, one has to note that the sharp (and in a global context idiosyncratic) turn to the worse coincided with Jean-Claude Trichet’s announcement at the beginning of June that it would increase interest rates. Immediately following the press conference, interest rates in Europe over all maturities shot up, leaving them now clearly higher than at the beginning of June (look at the instructive yield curves from before and after the June press conference below). Even though inflation in the US is clearly higher than in Europe, the dollar still under depreciation pressure, and budget deficits in the US being much larger than in Europe, European 10-year bonds now yield about 50 basis points more than US treasuries.
Figure 1: Upward shift of yield curve due to ECB press conference on June 5, 2008
By coincidence or causation, June was also the month in which the German ifo dropped sharply while it had kept up well during the time before. Of course, the high oil price might also played a role, but the strong euro and the increase in the interest rate certainly have not helped. Interestingly, both from order intake as well as from the details of the ifo index we see that companies see the domestic situation as a problem, not so much the global situation.
Moreover, there are some indications that the current monetary tightening is translating very quickly to the real economy. Banks have been quick to pass increases in interest rates to their customers. At the end of May, ING Diba, one of the largest direct mortgage banks in Germany, offered 5-year mortgages for 4.75 percent and the 10-year mortgage for 4.90 percent. Now the interest rates stand at 5.30 percent both for the 5- and 10-year mortgage. Judging from experience, such a sharp increase will certainly hit the construction sector.
So it might just be that the latest interest rate hike and the rhetorics which came with it were the proverbial straw which broke the euro-area’s economy’s back. For ECB critics, it certainly now is easy to make this case. Prepare for some more ECB bashing by the public going forward, especially if the US economy in the end weathers the crisis better than the euro-area.
The post has been co-posted at Eurozone Watch.