ECB: Treading with Care

Published on November 21, 2016

Since hitting their lows in July and again in September, German 10-year bund yields have risen by almost 50 basis points, from negative 0.20 to almost 0.3%.

European peripheral bond yields have soared even more dramatically, most notably led by Italian 10-year BTP yields that have climbed almost 100 basis points, from 1.1% to 2.1%, exacerbated by political risk over the December 4 Constitutional Referendum and fate of Prime Minister Matteo Renzi.

*** In light of already tightened conditions, and out of an abundance of caution to protect the hard fought recovery in Eurozone inflation that, while improving, is still not showing “convincing” signs of a sustainable recovery at its core, we believe it is now almost certain the Governing Council of the European Central Bank will announce at its upcoming meeting on December 8 it will extend its Asset Purchase Program (APP) purchases at a steady, unchanged pace of 80 billion Euros per month when it runs out in March 2017. ***

*** This marks a delay in what we previously believed was ¬†going to be an announced modest downshifting in the current 80 billion euro a month in bond purchases (SGH 10/5/16, “ECB: A Major Inflection Point”). But we still believe the ECB will seek to maintain the flexibility to adjust its bond purchase program if needed in 2017. And so, we understand the Governing Council may compromise on the terms of an extension and agree to a commitment to extend the program at its current pace that will be as short as six months, and possibly even less. ***

The Baton Not Passed

The year 2017 is shaping up to be – or at least increasingly hoped to be – the year of the long awaited hand-off from ultra-accommodative monetary policy to fiscal stimulus, from post-Brexit UK to Japan to, now, the United States under a Republican-led Congress and populist President-elect Trump.

But for all the efforts and exhortations of its international partners, topped off now by suggestions from European Commission President Jean Claude Juncker that the Eurozone countries target a cumulative increase in spending of 0.5% of GDP for 2017, the one notable absence on that fiscal expansion list continues to be the Federal Republic of Germany.

Indeed, with a domestic economy that is chugging along, and elections looming in the fall, Chancellor Angela Merkel, under cover of her hawkish Finance Minister Wolfgang Schaeuble, has committed to little more than modest increases in spending on defense, surely helpful in protecting challenges from the AfD and the right, while rejecting all “fiscal profligacy,” with little fear of a significant challenge from the Social Democrats and the left.

For the ECB, this means that for all of Italian Prime Minister Renzi’s loud efforts at bending the Stability and Growth Pact, and an expected additional spending of some 0.5% of GDP in Germany to absorb the influx of migrants that is already baked into the budget, the net impact on the Eurozone from the fiscal side for 2017 will be neutral, indeed a slight deceleration from two years of modest tailwinds.

And that means, at least for now, monetary policy will have to carry all the weight of maintaining the “substantial amount of accommodation” the ECB still feels needed to keep the recovery on track, and ensure the recent pickup in inflation holds through and is sustained at the core service level as well as on the headline side.

Do No Harm

But all is not bad news, and far from it. The ECB staff will release in December its quarterly forecast revisions that will include inflation forecasts for 2019 that are likely to be within “hailing distance” of the ECB target for inflation of 2% or just below.

Furthermore, ECB officials are cautiously more confident in hitting the inflation forecast for 2017 of 1.2%, and possibly even exceeding those levels, especially as energy prices continue to stabilize.

In other words, for one of the first times in recent memory, the ECB will no longer be disappointed with yet another downward revision to its forecast, and in fact, will be looking at stable to slightly higher numbers this time around.

And GDP, for the first time has finally clawed back above pre-Global Financial Crisis levels, and encouragingly, is being driven increasingly by domestic demand, and not just export growth.

With a recovery in mind, hawkish ECB officials will lobby hard to keep a good deal of optionality through 2017 to adjust the APP program if warranted, even if the time is not ripe to do so yet.

At issue, for now, and deserving still an abundance of caution is the breadth and durability of the rebound in the numbers, and most specifically, concerns that the base effect-led, year-on-year increase in headline inflation that has long been expected once oil prices finally stabilize may not yet be translating into a sustainable inflation impetus on the more important services side.

And so with upward pressure already on European yields, now exacerbated by emergent expectations for fiscal stimulus out of the United States after the surprise victory of Donald Trump in the Presidential elections, the ECB, led by President Mario Draghi, will be loath to pour fuel over the fire of a bear market in bonds with any reduction in the current pace of bond purchases.

The backup in yields of the last three months has also lifted the yield on over 300 billion Euros of bonds up over the -0.4% deposit rate, making these available for purchase again by the ECB under its current restriction barring purchases of bonds yielding below the deposit rate.

Combined, as we expect, with a short extension of the program, that means the ECB will now need to only make minor adjustments to the technical parameters of its bond purchase program to ensure it has an adequate supply of bonds to buy.

The markets, in other words, have already done a lot of the work, and heavy lifting, for the ECB, and perhaps even then some.

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