Overview: The German ifo has rebounded, driven by an increase in the expectations index. After dropping nearly vertically for seven months in a row, the improvement in expectations offers more than just a ray of hope that the worst is over in terms of the speed at which the economy is deteriorating, although uncertainty is exceptionally high and this is only one month's data. We have, however, previously seen a turnaround in German PMI new orders and the ZEW. Further, Belgian business sentiment and the US Philly Fed Survey new orders, which both usually correlate closely with ifo expectations, have rebounded. Note too that the decline in ifo expectations slowed markedly last month, indicating that a bottom was close.
Despite the good news, we do not see a rapid recovery ahead. The ifo is still at a very low level - and even lower than during the deep recession in 1992. Furthermore, the low ifo level is fully reflected in a sharp decline in factory orders. Thus the low level is not simply due to sentiment.
Details: The climate index edged up to 83.0 from 82.7 in December (consensus 81.3, DB 81.4), held back by a decline in the current conditions index, which dropped from 88.8 to 86.8 (though this was better than expected; consensus and DB 85). The expectations index rebounded surprisingly strongly to 79.4 from 76.9 (consensus 77.9; DB 78). The rebound in the expectation index is particularly important, as it is one of the best leading indicators for Euroland, typically leading production by three months. Furthermore, the expectations index usually leads the current conditions index. Thus the previous sharp decline in the expectations index suggests a decline in the current conditions index in the coming months.
Despite the rebound, the expectations index remains at a very low and worrying level. It is the second lowest since German unification, beaten only by the December 2008 reading. Germany is already in recession, and ifo still signals a severe weakening of the economy. On the two previous occasions the expectations index reached these low levels, the German economy went into recession (in 1993 and 2002).
The uptick in the climate index was driven by the retail sector rebounding from 88.4 to 90.4. Construction increased to 101.3 from 100.8, and wholesale edged up to 92.9 from 92.5. Meanwhile, manufacturing stood unchanged at 75.8. The distribution across sectors indicates that the rebound in the climate index was driven by the drop in inflation, which has stimulated real incomes.
Outlook and assessment: The data suggest we have left the worst behind us in terms of the ifo, and that the pace at which the economy is deteriorating is slowing. The German economy is struggling due to the financial crisis spreading into the emerging markets, most notably the important central and eastern European export markets. Furthermore, inventories will have to be run down. We expect the German economy will continue to suffer in the coming quarters.
The ECB will undoubtedly see today's ifo as a positive sign. However, the Euroland economy still looks very weak, and we expect this will force the ECB to cut rates further. We are currently projecting that it will lower the leading rate by 50bp at its March meeting to 1.5% (after de facto ruling out a rate change at the meeting in February). Depending on the data, we see a risk that the ECB may hesitate to cut so sharply, perhaps splitting the 50bp into two cuts of 25bp each.
Bond market implications: The change in ifo expectations has traditionally been an important driver for European bond yields. This is shown in the two charts overleaf. As the ifo has fallen it has supported growth worries and ECB cuts. If we indeed are seeing a turn in ifo now - even from a low level - this could be an important sentiment shifter in bond markets and support a bottoming of bond yields. This would be particularly true if we see a similar picture in US, where we expect the ISM to rise in the coming quarters. Negative growth surprises and deflation worries have dominated government bond supply worries over the past six months, but if growth indicators begin to surprise on the upside, absorbing the huge supply will become more challenging for the bond market.