“Look beyond the yield curve”

Turning points in the slope of the yield curve typically lead turning points in real Euro Area (EA) GDP. The rapid flattening/inverting of EA yield curves YTD has surpassed trends seen in 2015 and 2016 and raises concerns that “recession risks” are rising across the region.

To assess the severity of these risks, I examine trends in the key leading, co-incident and lagging indicators that represent the foundation of my “Money, Credit and Business Cycle” framework.

Growth rates in real M1 and lending to the private sector demonstrate robust relationships with the business cycle through time.

Real M1 tends to lead fluctuations in real GDP with an average lead time of four quarters. This reflects the fact that M1 is composed of funds that businesses and households can access quickly to support current spending.

Real household (HH) credit growth tends to lead slightly (one quarter) or have a co-incident relationship with real GDP. HHs typically increase their demand for credit when they expect house prices to recover and after house prices and interest rates have declined during a slowdown.

In contrast, real corporate (NFC) credit tends to lag fluctuations in real GDP with a lag of three quarters. NFCs typically rely on in internal sources of funds at the early stage of an economic recovery before turning to banks (and other external sources) for financing at later stages.

Real M1, an alternative leading indicator with a stronger and more stable historic relationship with real GDP than the slope of the yield curve, rebounded in February 2019 and is now growing at the fastest rate since February 2018. The relationship between real growth in M1 and real growth in GDP is well documented and is supported by CEPR evidence that shows that the real growth rate in M1, “went well into negative territory for prolonged period just before (or in coincidence with) all historic EA recessions.” (ECB Economic Bulletin, April 2019).

Real growth rates in M1 peaked back at 11.1% back in November 2015, but the moderation became more obvious during 2018 with a recent low of 4.3% in August 2018. A more sustained recovery began in February 2019 and the current (July 2019) growth rate of 6.7% is the fastest rate since February 2018. The current level of real M1 growth remains comfortably above the levels that the ECB associates with risks of recession in the near future.

Real growth rates in HH credit (a leading/coincident indicator) and NFC credit (a lagging indicator) are also at their highest levels in the current credit cycle. According to ECB data released last week, HH credit grew 3.4% YoY in nominal terms and 2.4% in real terms in July 2019. This is the fastest rate of growth since July 2009 and the fastest rate of growth in the current cycle. France (1.4% contribution), Germany (1.2%), Benelux (0.3%) and Italy (0.2%) were the main drivers of growth. NFC lending grew 3.9% YoY in nominal terms and 2.9% in real terms. Again the real growth rate was the fastest in the current cycle and the fastest rate of growth since June 2009. In the NFC sector, France and Germany are again the key country drivers, both contributing 1.7% of total nominal growth.

In other words, the message from the EA banking sector is more consistent with current ECB and EC growth (subdued but stable) forecasts than with fears of an EA recession.

However, with growth remaining below LT trends and with inflation 1ppt below the ECB’s target, expectations that the ECB will cut rates this month and restart QE are likely to be met.

Please note that the summary comments above are abstracts from more detailed analysis that is available separately.