I argue below that the ECB seems likely to at least meet market expectations for easing on 3 December, despite EA financial conditions having recently eased. While tightening financial conditions contributed to the ECB turning dovish, the reverse doesn’t apply. The fragile EA macro situation means that ECB can’t take the risk of the recent easing of financial conditions reversing should they disappoint. There also remains a way to go in attaining more appropriately loose financial conditions and ensuring that their effects transmit to the real economy and inflation. Indeed, recent Draghi and Praet concerns about waning core inflation pressures and potential loss of ECB credibility likely give a better indication of the direction of travel (a dovish one!). Moreover, Draghi also has a record of over-delivering when the chips are down and the ECB strategy seems to be to keep ahead of market expectations.
So the risks remain skewed to the ECB exceeding market expectations on 3 December: my forecasts remain for a 10-20bp deposit rate cut and a 6-12 month PSPP extension, albeit now with a greater chance of municipal bonds being included. Overall the surprise seems most likely to come via a larger than expected deposit rate cut (the market is pricing in 10bp but 20bp is easy to envisage). That would have the double-benefit of having the largest FX impact and potentially giving EA animal spirits a much-needed immediate jolt.
So EUR weakness seems likely to have further to run (taking it further into the required “undervalued” territory) assisted by the likely December Fed rate hike, BoE rate hike expectations probably consequently being brought forward in the coming months (the Fed “mini me” tag will likely persist, see here) and the BoJ continuing to stand pat. The caveat is that if the Fed hike or EM concerns reduce market risk appetite that would work against EUR weakness (EUR has become a funding currency). But that also provides the ECB with an extra incentive to be dovish to curtail that possibility (by supporting market risk appetite and increase the attractiveness of EUR-funded carry trades). Further declines in European bond yields and further compression of periphery-core spreads also seem likely (although Portuguese politics means that PGBs may benefit less, see here).
Tomorrow’s ECB minutes will be interesting for any further insights into the GC’s change of heart last month and hints about the different options. That said, Draghi’s “work and assess” focus means that we shouldn’t expect too much. More recent dovish ECB comments, particularly from Draghi and Praet, likely give a better guide to prospective ECB policy rather than a more detailed examination of the state of play nearly a month ago.
Tighter financial conditions contributed to ECB dovishness
In August I argued that the tightening of euro zone financial conditions (EUR appreciation, rise in real interest rates, steeper yield curve and equity price falls) provided a strong case for ECB easing. And Draghi subsequently surprised dovishly in October (see here) by explicitly signalling that further easing was on the agenda for December, with a further depo rate cut was no longer verboten, and a message of “work and assess” on policy options. A further interesting aspect, which seems to have been underweighted by the market, was that Draghi expressed concerns about ECB credibility. That theme has recently been echoed by ECB Chief Economist Praet yesterday.
Financial conditions have eased after Draghi became more dovish again
EA financial conditions have eased somewhat since the ECB’s dovish turn:
• Nominal EA yields have fallen, especially at the short end. Two year bunds today touched record lows (-0.38%). Given the accompanying rise in 2y US yields (generated by growing expectations of a December Fed liftoff) the 2y Bund-US Treasury gap has reached the widest since 2006. But French yields have only been a little less negative than Bunds and even Italian 2y yields have been hovering just above zero. Longer-dated yields have been less on a downtrend, with 10y yields fluctuating more and exhibiting some similarities with US yield movements.
• The EUR has fallen back quite sharply, with the TWI down 3.6% since Draghi’s dovish press conference. The 6% EURUSD decline, to the 1.06-1.07 range, has obviously also been helped by the Fed’s more hawkish tilt. And that’s fostered some suspicions that the ECB could be tempted to leave the heavy lifting to the Fed raising rates on December 16th. But EURGBP is also down around 5% since the October press conference, as MPC’s attempts to differentiate themselves from Fed (see here) haven’t been that successful. Meanwhile EURJPY is down 3.3%: I argued here that EURJPY downside was attractive given that BoJ easing was (then) being overpriced, with the trade also usefully abstracting from Fed liftoff uncertainties and the knock-on effects on market risk appetite (given that both EUR and JPY are risk-off currencies).
• Euro area inflation breakevens have rebounded a little. And their previous worrying link with oil prices seems to have dissipated somewhat. Consequently EA real medium-term real interest rates have edged down a little.
• European equity prices have risen sharply: the 4.9% gain in the Eurostoxx 50 and 7.1% rise in the Dax exceed the 3.2% rise in the S&P500 or indeed the 1% fall in the FTSE 100 over this period.
Easing financial conditions shouldn’t hold back ECB easing
Some parts of the market seem to be starting to think this easing of financial conditions in itself makes the ECB less likely to act on 3 December (or less likely to surprise on the dovish side), with recent substantial rise in the likelihood of Fed starting hiking in December also playing into that narrative (via greater EURUSD downside). I agree that the financial market developments will have provided some succour to the ECB, perhaps particularly the EUR decline given that the ECB seemed increasingly concerned about nascent EUR strengthening (see here). But there are several important reasons why this shouldn’t make ECB easing on 3 December less likely.
First, fundamentally much of the easing of EA financial conditions has only occurred because Draghi managed to exceed dovish expectations last month and the subsequent fanning of easing expectations. So should the ECB disappoint market expectations (which have priced in a 10bp deposit rate cut and some form of QE extension) many of those improvements in financial conditions would likely reverse: they are endogenous to the policy expectations rather than generated by an improved macro environment. And given the fragile macro backdrop, with GC members acknowledging that the situation is improving more slowly than expected, the ECB will likely be very reluctant to run that risk. So the ECB’s policy objective is as much about cementing the gains in financial conditions achieved thus far via the signalling mechanism as about getting further large improvements. That said, I think that the risks are skewed once again to the ECB exceeding market expectations, with a deposit rate cut to -0.4% a live possibility, in which case financial conditions would likely ease further (especially short rate and EUR declines).
Second, the ECB can’t really take the chance of “leaving it to the Fed” since:
(i) The ECB obviously moves first and a Fed hike isn’t yet a 100% certainty, with EURUSD likely rebound if they don’t raise. A December hike currently looks like a very strong possibility (Fed funds futures are pricing in a 64% probability) but there’s still another month of data, Vice Chair Fischer’s (limited) concerns about USD strength could yet gain ground and the implications of the Paris terrorist attacks need to incorporated;
(ii) If the Fed does raise rates it could potentially hit market risk appetite and hence exert upward pressure on the EUR as carry trades are unwound. So, strategically, aggressive ECB action can counter that possibility by both supporting risk appetite and by further increasing the attraction of EUR-funded carry trades (deposit rate cuts seem likely be more impactful on the EUR than QE extensions). That said, as NY Fed’s Dudley discussed today, the potential Fed hike has been widely telegraphed, which should reduce make a risk off event less likely.
Third, despite their easing it’s arguable that EA financial conditions are not yet sufficiently accommodative: the difficulties in getting EA growth going (see below) imply e.g. that the EUR needs to (substantially) undershoot its medium term “equilibrium” for a while. But more practically there are several less positive developments in financial conditions under the surface:
(i) The increase in the slope of the EA yield curve which occurred from mid-April hasn’t really been reversed (as discussed above, 10y yields haven’t mirrored the declines in shorter yields). In May Benoit Coeure argued that flattening the yield curve was an important component of monetary easing. And that EA yield curve is steeper than the Japanese yield curve (it’s flatter than the US or UK curves but arguably needs to be). That said, Coeure’s view predates the ECB’s apparent volte face on rate cuts.
(ii) Even though EA inflation breakevens have rebounded a little, contrary to oil price movements, the bigger picture is that they remain little changed from their levels when QE was announced in January. Moreover, their more recent apparent correlation with EURUSD fluctuations is also a little concerning from an ECB credibility point of view, although the both moves seem driven by ECB easing expectation.
(iii) The rise in EA medium-term real interest rates from mid-April, apparently prompted by Draghi’s statement that “markets need to get used to volatility” has also not been unwound. So on this basis monetary policy remains tighter than it was in Q1, by a not-insubstantial 60bp.
(iv) Portuguese political uncertainties have been associated with widening of PGB-Bund spreads, although as I argued here the PSPP support, with the Bank of Portugal purchases being the longest maturities, has papered over the cracks of high Portuguese debt levels and structural weaknesses.
Fundamental reasons for ECB easing remain strong: Praet’s “dangerous cocktail” of de-anchored inflation expectations and economic slack
More fundamentally, there are growing doubts about whether the improved financial conditions are translating the economic recovery gathering momentum and whether that in turn will translate into meaningful inflation pressures. So the overarching macro case for further ECB action remains strong. Indeed, as I’ve previously discussed, ECB staff could be using an improved forecasting model to produce the all-important December forecasts (ECB Vice President Constancio’s Jackson Hole paper alluded to this) which could rectify the ECB’s persistent over-optimism. That’s certainly consistent with Draghi and Praet’s recent concerns about inflationary pressures and ECB credibility as well as Praet’s statement that the ECB was adopting a more holistic approach in the current forecast round.
Last Friday’s Q3 GDP data were obviously disappointing (0.3% q/q growth, down from 0.4% in Q2). And on Monday ECB Chief Economist Praet noted that the “European economy is having difficulties consolidating its recovery” arguing that “long-term decisions about investment are not being made because of uncertainty” and that ECB policy is trying to stimulate risk appetite (as I discussed above) although he acknowledged that could be dangerous i.e. raise financial stability issues. But overall Praet judged that the downside risks to the economy are growing – which I agree with – which accords with Draghi’s 12 November caution that “Downside risks stemming from global growth and trade are clearly visible.”
I’ve previously been particularly concerned about the lending dynamics, and hence the prospects for EA corporate investment for a number of months (see here and here). The combination of continuing high corporate debt burdens and uncertainty about the strength of the recovery represent headwinds to corporate loan demand and investment intentions. And the ECB has previously been overly-sanguine in its interpretation of their bank lending survey. So the recent fallback in corporate lending growth to near-zero on an annual basis, with weak underlying flow dynamics, wasn’t particularly surprising. And absent a sudden uptick in animal spirits in the EA it’s difficult to see CAPEX strengthening markedly to broaden out the EA recovery (indeed, CAPEX’s negative Q2 GDP contribution could persist into Q3 and weak foreign demand conditions mean that net exports could continue to struggle despite the EUR’s depreciation).
I also remain dubious about the relatively-sharp inflation pick-up envisaged in the September ECB staff forecasts – and they could be well be revised down with the ECB’s updated forecasting model. Praet noted that mechanically-updated forecasts would likely see the projected horizon for getting inflation back to target would likely be extended yet again. I’ve previously worried that there were limited signs of inflationary pressure coming from the high-unemployment EA labour market: EA wage inflation notably lags that in the UK or the US. And Draghi echoed those concerns on 12 November: “The protracted economic weakness of the past years continues to weigh on nominal wage growth, and this could moderate price pressures as we move forward…this suggests that a sustained normalization of inflation could take longer than we anticipated”.
Monday’s marginally better than expected HICP release, with the 1.1% core inflation being the highest since August 2013 was welcome, although such near-term developments are relatively unimportant for the ECB. Rather Praet’s concerns on the same day about “A possible de-anchoring of inflation expectations together with a lot of slack is a dangerous cocktail” is a far better guide to the direction of travel of ECB policy. Indeed, Praet’s comment that “we have some signals that these inflation expectations are still fragile” seems linked to the concerns about inflation breakevens I detailed above.
And given that Praet’s concerns follow Draghi’s 12 November comment that “signs of a sustained turnaround in core inflation have somewhat weakened” it appears that they may well be preparing the market for a relatively-large downgrade of the inflation forecasts (with the new improved model), thus holding out hope for a relatively-aggressive policy response. Comments from Praet and Draghi have previously, unsurprisingly, been good guides to the direction of travel of ECB policy. That currently seems to be in a very dovish direction. And Draghi has shown several times that he can facilitate the Governing Council exceeding expectations when the chips are down (even if other GC members have been dragging their heals a little e.g. Hansson arguing that there is “no convincing reason” to ease in December or Mersch commenting that “nothing has ben decided”).
Here the Reuters leak that the GC was considering including municipal bonds in the PSPP is probably not a coincidence: ECB strategy has been evolving to staying ahead of market expectations, with dovish policy comments helpfully dropped in when market expectations appear to sag (or EUR weakness may be waning). That said, the municipal bond purchase option seems most likely to be a delayed (slow-burn) one given the practicalities to be overcome.
So my bias remains that if there is going to be a surprise on 3 December it will come via a larger than expected deposit rate cut, where up to 20bp is possible. That’s because a deposit rate cut will likely both have the largest FX market impact and may well be most effective at supporting risk appetite and animal spirits: at the least the impact would be more immediate than an extension of the existing PSPP programme (which I also expect). The EA economy currently seems to require a jolt rather than a gentle “more of the same” nudge.