ECB after the dovish Fed: QE extension virtually a done deal, expect further efforts to forestall EUR upsides

The Fed’s apparent dovishness, with markets pricing a delay in hiking until 2016 (see my accompanying post) on balance increases the likelihood that the ECB will on 3 December announce an expansion or (more likely) and extension of their QE programme (PSPP) beyond September 2016 end-point.  As I anticipated, Draghi opened the door to such further easing at the September press conference, with his comments indicating a greater focus on the EUR’s strengthening and an apparent hope that Fed hikes would ameliorate the nascent EURUSD upward pressure. That said, I’ve previously argued that the adverse impact on risk aversion of a Fed hike could be an important counterveiling force given, that ECB actions have turned EUR into a funding currency.

Growing expectations of such further ECB could see EGB’s rally, with the recent widening of periperal-bund spreads retracing and breakevens recovering (their strong link with oil prices over the past eighteen months shows limited signs of weakening) although likely continued weak HICP data suggests potentail further falls. The fallback in EA HICP (both headline and core) in the final August data this week will certainly have disappointed the ECB. Moreover, the ECB easing view is now more widely held than when I started arguing for it a couple of  months ago (when markets were mysteriously romancing the EA reflation trade) and markets may well question the efficacy of ECB actions.  .

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The big picture is that if relatively-robust US domestic demand/labour market is having difficulty generating inflation there is little hope of the ECB’s rosy inflation forecast being achieved.  Although the forecast was revised down a couple of weeks ago it still reaches 1.7% in 2017 – a sharp rise from 1.1% in 2016 and handily not quite far enough away from 2% to trigger immediate action.  After all ECB consensus for the need to again needs to be built and acting again so soon after launching QE could undermine confidence/credibility further.

But this is an economy where the ECB forecasts persistently high inflation (it only falls to 10.1% by 2017), labour demand indicators look weak across countries (see here) and the Phillips Curve also looks flat.  So the ECB’s forecast that compensation per employee growth will rise to 2.1% in 2017 from the flat 1.3-1.4% range over the past year is certainly open to question. And this helps explain why EA consumer confidence has fallen back in recent months – with unemployment expectations rising and major purchases attitudes flatlining – an inauspicious backdrop to the ECB expectation that consumption will be the main driver of the EA recovery (altough recent GDP contributions have been solid).

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The ECB’s anticipation that oil prices will bounce back to $61 in 2017 also looks like a bit of a hostage to fortune given oil market demand-supply conditions (Goldmans recently put out a $20 scanario).

My previous view that the ECB was set to start sending more dovish signals and become more concerned about the euro’s appreciation have been borne out in the ECB press conference and subsequent ECB GC member comments (Praet, Coure, Constancio). The consistent theme is that EUR strength matters because it puts downwards pressure on fragile EA inflation and activity, rather than the ECB having a EUR target (obviously!). And that forthcoming monetary policy divergences should see EUR fall (no mention of the unintended consequence of EUR being supporting in risk-off periods as ECB policy has turned it into a funding currency!).  So it’s notable that Coure was quick to hit the wires on Friday after the Fed’s dovish decision, stressing the likely continued divergence between US and EA performance. That said the initial EURUSD bounce to around 1.145 after Fed decision had unwound by the close of US trading.

ECB concern about EUR strenthening reflects that fact that it represent a more important transission QE channel than in other countries (given less equity holdings).  And its demonstrated by the latest ECB staff’s macro projections featuring a scanario where a rise in  EURUSD to 1.21 is projected knocks up to 0.5pp off inflation.  But even that may be an underestimate: the assumed rise in the EUR TWI is half as large as they’ve used previous correlations.  And that seem likely to understate the TWI rise given weak EM FX (the TWI has recently been more resilient than EURUSD).  So EUR strength could well represent more of a headwind to inflation picking up than the ECB anticipate.

That said, the Fed’s dovishness has provided a little relief to the tightening of EA financial conditions I highlighted here. 10 year bunds rallied nearly as much as treasuries and 30 bunds and 5y5y real rates actually rallied more than their US equivalents (see chart).  This is, however, only a smallish unwind of the cumulative tightening of EA financial conditions since around April.

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My previous concerns about weak credit growth inhibiting euro area growth were on Wednesday given support by the OECD interim economic outlook. This argued that EA growth was 1pp weaker than implied by the tailwinds of ECB action, EUR depreciation and oil price falls. And it laid the blame at the feet of continued high Eurozone debt burdens, with considerably less deleveraging and writing down of bad loans than in the US. Specifically, combined debt of EA households and non-financial corporates is over 205% of GDP down less than 10pp since the crisis compared to the around 25pp fall in the US equivalent. Such debt burdens will likely hold back demand for new lending, and hence consumption/investment despite the falls in borrowing rates which Draghi likes to trumpet. In fairness to the ECB they do mention such debt issues as a headwind several times in their macro projections documentation but I haven’t yet uncovered any quantification.

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The latest data do show a small pick up in lending flows to corporates – and it’s this “credit impulse” which seems to drive investment (see here). But it’s hard to get away from the fact that 12m lending growth to non-financial corporates of 0.9% is weak, and significantly weaker than the US, so further improvement is needed to get to a “glass half full” view of the situation. Moreover, you can turn around the ECB’s argument for why “business investment is set to regain momentum” with the first two arguments being “demand trends” and the “need to modernise the capital stock after several years of subdued investment”.  The risks seem skewed to the former being weaker and the latter amounts to “its been weak so it’s got to get better” whereas high debt levels and an uncertain environment suggest delaying investment (there’s a positive option value of waiting).

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Having said all of this, my central case is not for the EA to fall back into recession – after all ECB policy has become more stimulative (but they need to up the ante), the beneficial terms of trade effect from the oil price fall will end to support consumption and perhaps corporate profits (although I note here that there’s little evidence of that after previous oil price falls) and fiscal policy looks like being less of a growth drag than in recent years. And the strengh of money, in contrast to the weakness of lending, shouldn’t be ignored.  For example, there’s an ok relationship between EA retail sales growth and M1 growth 12 months earlier – although it currently suggests limited upsides rather than anything particularly startling. Its also possible to get a stronger story for EA IP prospects based upon M1 growth if you choose your chart axes and time period carefully, but to me M1’s link with retail sales seems more intuitive.

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Rather a period of continued under-performance relative to more dynamic economies like the US and the UK seems like the most likely scenario.  Indeed, its notable that the ECB forecasts put trend EA growth rate at only 1% pa, as they acknowledge that structural reforms are proceeding slowly (hence Draghi’s habitual comment about the need for other policymakers to pull their weight). So EA inflation could actually head up for the “wrong reason” of adverse supply trends rather than strong demand trends.

The likelihood of further ECB actions will obviously depend on how the data evolve – next week’s PMI releases will be intereting – but at the moment it seems more likely than not that the ECB will expand or (more likely) extend PSPP in December.  We may well also get some further clues when Draghi appears in front of the European Parliament next week.

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