The election of Donald Trump as president of the United States triggered euphoria sentiment in the financial markets. Many key indicators have risen sharply in recent weeks, and inflation expectations have also surged. However, we share the view of most economists and market participants and do not expect Trump to be able to implement all of his election pledges. But what would the repercussions be if the new US president did actually realise the growth he has promised?
We have developed a theoretical scenario which, although fairly unlikely to be realised, has at least become more probable in recent weeks. In this scenario, based on a hypothetical increase in US inflation to 3.9% and GDP growth of 3.5%, yields on 10-year USTs would be significantly higher by the end of 2018 at 5%. Consequently, yields on ten-year Bunds would also reach around 3.2%, with an expected positive knock-on effect on European inflation and growth figures.
Given the currently positive correlation between Bund yields and EMU spreads, the yields of EMU sovereign bonds would be likely to increase much more steeply in this theoretical scenario. We estimate that yields of 10-year Spanish sovereign bonds would therefore reach 5.2% and yields of Italian sovereign bonds would amount to 5.8% by the end of 2018.
The repercussions in terms of debt growth in the next two years would be noticeable, but not yet dramatic. The greatest impact would be felt in Italy, where the debt ratio would rise to nearly 135% within two years. The budget deficit would surge to 3.5% of GDP. France’s debt ratio would increase to 99%, whereas levels would stagnate in Spain relative to GDP, and would even fall in Germany. However, in overall terms, the impact of the “Draghi dividend” (the positive impact of expansionary ECB monetary policy on public budgets) would be likely to weaken, restricting fiscal scope. There would also be a danger that the scaling back of the PSPP made necessary by higher inflation would lead to liquidity shortfalls in the EMU sovereign bond markets. The absence of the ECB as a structural buyer of bonds could make refinancing more difficult.
The EMU countries would have to react to such a scenario, for example by reducing the duration of their debt. In an extreme case, bailout programmes such as purchases in the secondary and primary markets by the ESM or, as a last resort, the deployment of OMTs, would also be facilitated by the ECB. Despite lingering legal doubts, these measures would initially be sufficient to prevent a repetition of the sovereign debt crisis of 2011/12