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Mixed signals for the euro

Monetary growth points to a recovery in the eurozone, but the yield curve does not
September 19, 2019

The troubled eurozone economy could get some good news next week, because the European Central Bank might report that growth in the M1 measure of the money stock – currency plus overnight bank deposits – has risen.

This matters, because annual growth in this measure of the money stock, adjusted for inflation, has been a great lead indicator of output growth. Accelerations in it in the late 1990s, 2003 and 2015 led to faster economic growth, and slowdowns in 2007, 2011 and last year led to falls in output. Since 1996 the correlation between annual growth in M1 (adjusted for inflation) and in industrial production in the following 12 months has been a hefty 0.68. With next week’s figures likely to show real M1 growth near a two-year high, we have therefore reason to hope the region will soon pull out of its current malaise, which has seen industrial production fall 2.3 per cent in the past 12 months.

But, but, but. We also have an indicator pointing to continued contraction. Yields on 10-year German bonds are now below those on three-month interbank rates. When this has happened before, as in 2000 and 2007, output has subsequently fallen. In fact, the correlation between the gap between 10-year yields and three-month interbank rates and subsequent annual growth in industrial production has been almost as strong as that with real M1, at 0.6 since 1996.

Curiously, M1 and the yield both contain information about future output that the other does not: even if we control for the other, each has strong predictive power.

A lead indicator of output growth that combines the two can explain almost two-thirds of the variation in output growth since 1996. This indicator is now pointing to a further fall in output over the next 12 months – of just over 1 per cent.

We would need to see M1 growth of over 10 per cent to counteract the pessimistic message coming from the bond market.

So, is there any comfort that equities might draw from this?

One possibility is that, by now, the bad news about the economy should be in the price. After all, if bond markets see a downturn coming, should equities also?

My problem with this is that while equity investors should anticipate weak earnings in advance – if they are doing their job properly – they are not so good at anticipating that recessions reduce their appetite for risk. As Harvard University’s Matthew Rabin has shown, people tend to project their current tastes into the future and do not anticipate them changing.

Instead, we have another hope. It’s that bond markets might have been seized by a positive feedback loop. Falling yields have prompted fears of recession, which in turn have led to a further inversion of the yield curve, which has again intensified fears of recession triggering yet more buying of bonds.

An inverted yield curve usually predicts recession because it contains the wisdom of crowds: low yields are a sign that investors expect hard economic times. If, however, we now have such a positive feedback loop, then the bond market embodies not the wisdom of crowds but rather an information cascade – a phenomenon in which people act in the belief that everybody else knows something when in fact they do not.

If this is the case, then even mildly good news could break the loop and cause yields to rise – in which case equities could do very well. I’m not at all confident this will happen, but it is the best hope for the stock market.