The early 2016 China-induced financial market volatility, including oil prices hitting twelve-year lows below $30 and sharp equity price falls, reinforces my existing bias to eventual further ECB easing in 2016 (alongside other central banks becoming more dovish e.g. Carney’s comments today, Bullard’s recent concerns about US inflation expectations and others like the Riksbank biased to easing further). But ECB action on Thursday seems highly unlikely given the proximity to their market-disappointing December easing: they will certainly want to take stock of developments and evaluate whether the market moves persist. The main message seems likely to be that they are watching vigilantly and assessing developments, with Draghi probablty repeating the ECB’s willingness to ease further if appropriate. Actual further ECB action, likely a further small (10-15bp) deposit rate cut rather than any change to the APP, will rather likely come in March at the earliest (with new ECB forecasts, featuring 2018 for the first time) but could slip to June given Governing Council divisions. In the interim ECB interactions with markets could prove tricky.
The main more detailed points are:
• EA equities have fallen more than elsewhere and the EUR TWI has risen towards levels associated with dovish ECB rhetoric last year.
• The oil price collapse will eliminate the base effects that the ECB is banking on to raise inflation in 2016: 0.6% headline HICP looks like a better bet than the ECB’s 1.0% forecast and negative prints can’t be ruled out. So the pressure for ECB easing will likely grow.
• EA 5y5y inflation breakevens have once again fallen alongside the oil price plunge, although some ECB members have started downplaying their policy significance and US breakevens are also down sharply.
• There’s no sign of inflationary pressures from the labour market or in the supply chain, where the effect of continued China producer price deflation will continue to be felt.
• EA activity is supported by several (fading) tailwinds but also faces some structural headwinds.
• Today’s ECB bank lending survey shows the strongest corporate credit demand since 2005, although credit supply conditions look to be flat-lining, and there’s some evidence of improved investment intentions.
• The ECB meeting Account reveals a divided ECB Governing Council, overly-sanguine about China/EM prospects, but more open to further rate cuts than APP tweaks (although recent press reports indicate that a below-target 2018 inflation forecast wouldn’t prompt some ECB members to act).
• The EUR has been supported by the high risk aversion dominating FX markets, even the range-trading EURUSD but more obviously EURGBP, although the ECB should be grateful that these risk aversion impacts seem to have been a little smaller than previously (EURJPY has fallen and the link with equity prices has loosened).
• Risk aversion developments also seem likely to dominate short term EUR prospects and could go either way with global factors biased to further deterioration while Draghi could potentially calm the situation if he can get the ECB hawks agreement to signalling that they’re considering further easing (a big if given the December experience and markets may also be sceptical about ay such signals).
• EURUSD seems likely to continue to range-trade until the key March ECB and Fed meetings, albeit with a downwards bias if markets calm down. EURGBP downside will likely be limited by Brexit uncertainties and associated BoE dovishness over the next few months. But further EURJPY downside seems likely.
Oil price falls call ECB assumption of base effects supporting inflation into question
The fundamental reasons for the disappointing ECB easing in December were: (i) the ECB decided not to adopt a risk-management approach – instead settling for “adequate” compromise measures to get the hawks on board (see below); and (ii) the staff macro projections were surprisingly optimistic and indeed little changed from September – growth forecasts to rise to 1.7% in 2016 and 1.9% in 2017 while was inflation expected to hit 1.0% in 2016 and 1.6% in 2017 hardly screamed the need for a shock and awe policy response. But the ECB meeting Account acknowledged the boosts provided by the positive financial market sentiment engendered by the expectations of significant ECB easing (I argued here that the ECB should realise that such effects would unwind rapidly should they significantly disappoint markets, but that seems to have been overly-optimistic).
But it’s important to realise that the forecast 2016 inflation pick-up is heavily driven by the base effects of previous oil price falls dropping out of the calculation and the ECB assumption of oil prices rising back to $52.2 in 2016 (and $57.5 in 2017). The latest ECB Economic Bulletin (see here) explains that oil-related base effects support HICP inflation around the turn of the year and again from June onwards (see first Chart below). Unfortunately a $52 oil price now appear an even more distant hope, given recent falls below $30 and the apparent growing excess supply in the oil market: an inconclusive outcome to December OPEC meeting and prospective resumption of Iraq oil supply have got the EA worried that the oil price rout could intensify (see here), even if Iraq deputy oil minister said that production increases will be “managed” to ameliorate the price impact.
And the second chart illustrates that the positive base effects the ECB is banking on won’t eventuate even under the entirely-reasonably scenario of oil prices remaining around $30. The chart examines the direct effect operating via the energy HICP component, which makes up 10.6% of the HICP basket and is unsurprisingly highly-correlated with oil price inflation. The absence of the positive base effects, plus the more negative base effects between February and May, will add to the ECB pressure to ease: it will be harder than usual to look through them. And obviously, EA inflation prospects would be even worse if oil prices were to fall further (which is where I’d put the risks). The chart illustrates that the increasingly-discussed scenario of $20 oil prices would see energy inflation continue to pull down strongly on headline HICP inflation, significantly increasing the chances of further negative headline HICP prints.
Overall the lack of supportive base effects means that HICP of around 0.6% in 2016 looks a better bet than the ECB’s 1.0% forecast and further negative headline prints along the way can’t be ruled out. This will see the ECB under intense pressure to act, with the pressure probably peak around mid-year, even if EA growth prospects continue to slowly improve (see below).
EA Inflation breakevens again heading down, but ECB could pay less attention
Moreover, the 5y5y EA inflation breakevens, which the ECB has thus far placed great faith in, are already down by 20bp since the December ECB disappointment (and alongside the oil price plunge). Indeed, 5y5y breakevens appear to have over-reacted to the oil price plunge when the latter is measured in y/y changes (but not when levels are examined). And at face value 5y5y breakevens marginally above 1.6% doesn’t really sound consistent with the ECB objective of “close to but less than 2%”. And such negative dynamics seem more likely than not to likely extend should EA inflation outturns continue to disappoint.
So the big picture is that ECB staff look to have been premature in concluding that “the monetary policy measures put in place since June 2014 had been critical in arresting a process of an unanchoring of inflation expectations”. And Draghi looks to have jumped the gun in claiming at the December press conference that “after a long time – the correlation between our inflation expectations measures and the current inflation or the oil price has decreased or has just disappeared”. I warned that the oil-breakevens dynamic could reassert itself here. These are indeed worrying times for ECB credibility.
That said, some (hawkish) GC members also seem to be appreciating the trap they’ve made for themselves by their strong policy focus on 5y5y breakevens. The ECB meeting Account noted that low inflation breakevens “need not signal an unanchoring of expectations. It could also be due to the existence of negative and time-varying inflation risk premia” and this “suggested that some caution was necessary in the interpretation of market-based measures of inflation expectations. Reservations were expressed, in particular about the five-year forward inflation-linked swap rate five years ahead, given market focus on this specific measure for gauging ECB policy, which might in turn undermine its information content.” And some support for the idea that inflation breakevens are overstating the underlying fall in EA inflation expectations is provided by: (i) US 5y5y breakevens also falling sharply recently this year (prompting Fed Governor Bullard to worry) again correlating with oil price falls and EA breakevens (although the levels difference persists); and (ii) the regular New York Fed model update continues to imply that the fall in US breakevens has been driven risk premia (see here). That said, such models based estimates are uncertain and the estimated underlying inflation expectations can tend to be tied down by the survey-based measures plugged into them.
But it’s also not clear from the ECB meeting Accounts how widespread the scepticism about 5y5y breakevens is within the ECB. So it will be important to watch out for this at future ECB press conferences (starting Thursday), as it would militate against ECB action. Alternatively, the ECB could shift away from its strong focus on headline inflation: there’s been murmurings within the GC about placing more weight on core inflation (although that’s also disappointingly fallen/flatlined in recent months).
No sign of EA inflationary pressure in the labour market or prices pipeline
The fundamental challenge for the ECB is to identify exactly where inflationary pressures are going to come from. There’s certainly not much sign of it in the labour market. Rather labour cost growth slowed to a measly 1.1% y/y in Q3 (latest data) from 1.6% in Q2. Unit labour cost growth was even weaker at only 0.6% y/y in Q3. The gradual falls in unemployment haven’t really eaten into the large labour market slack. And the ECB forecasts don’t envisage unemployment falling below 10%. Broader measures like average hours worked and under-employment rates also confirm significant labour market slack (although obviously the German labour market is tighter).
Moreover, there’s little sign of growing inflationary pressure in the price supply chain. Headline EA producer price inflation remains stuck below -3% y/y while the core measure printed -0.7% in November. And, like the rest of the world, the EA will likely continue to feel the effects of the disinflationary pressures emanating from China given -5.9% producer price inflation and CNY depreciation temptations. The inflationary impulse from the previous euro depreciation will also be fading, given the gradual EUR TWI rise since April 2015.
Several (declining) tailwinds supporting EA activity…..but downside risks remain
Of course, oil price falls also have the positive aspect of supporting EA real income growth: they amount to a tax cut for EA consumers and firms (the EA’s oil import bill has fallen by 2% of GDP since 2014) and unlike the US and the UK the EA doesn’t have an oil-producing sector to have its investment crimped by the oil price plunges. That said, the uncertainty effects associated with the recent oil price plunge them, leading to higher household savings rates and investment delays, work against such boosts in the current environment (as do sharp falls in equity prices). But EA growth should also be supported by accommodative monetary policy (albeit with real interest rate rises being the corollary of lower inflation expectations), the EUR’s previous fall (albeit increasingly less so given the rise since April, although German export expectations have also notably held up despite the relatively large China exposure) and less restrictive fiscal policy (flexibility around the stability and growth pact, Germany fiscal strings loosening in response to the refugee influx) and continued employment growth (see here for the ECB take).
And ECB members will likely have taken some satisfaction about the improvement in EA PMIs – as the small upward revisions from the flash estimate (except for France) represented the only really upside surprise in the early-January round of global PMI releases and all EA members returned to above 50 (and many outperformed the UK). That said, the PMIs still only indicate moderate growth (0.4% in Q4), which is big-picture pretty disappointing given the amount of stimulus and the large EA economic slack to be run down before inflationary pressures start showing up. Moreover, recent “hard” EA data haven’t been that impressive: both EA retail sales and industrial production recently disappointed (see Chart), although new car sales have been strong.
But more fundamentally the EA recovery is only going to strengthen, and thus start reducing economic slack, if the weak investment (capex) dynamics of recent years comes to an end. And it’s notable that the ECB actually downgraded its investment growth forecast in December (even before the uncertainty impacts associated with recent market turbulence kicked in). I’ve been sceptical about a major upturn given the weak EA growth dynamics and uncertain outlook, corporate debt overhangs, high non-performing loans in some countries and only small rises in loan demand/supply balances in the ECB’s bank lending survey. But several developments have made me a bit less downbeat.
First, today’s ECB BLS update shows that in Q4 corporate credit demand rose to its highest level since 2005 Q4. That said, the investment demand component rose less and is further below its previous peak. And the less good news is that banks expect corporate credit demand to plateau in Q1 and that their credit supply shows no signs of further loosening. So it’s probably more likely that we’ll see a a continuation of the very gradual rise in actual lending to non-financial corporates rather than a sharp uptick. Loans to non-financial corporates rose by a modest 0.9% y/y in November (up from 0.6% in October), albeit that uptick actually reflecting positive (but erratic) rather than just base effects.
Second, the European Commission survey of EA corporate investment intentions rising to a record high, with the gap to UK investment intentions unusually large. But there’s again some cavests: (i) the survey (the only one available for the EA) is rather stale and so predates recent latest period of global economic uncertainty; (ii) the “record high” also isn’t that high in absolute terms – it’s not hard to set a record when the history is so weak; (iii) Spain is the only “big” economy where things are looking strong (see Chart).
But the growth support from the euro’s previous weakness may also start waning given that the TWI has been edging up since last April. And overall probably the best argument for EA growth eroding economic slack is the “bad” one that EA trend growth is weak so the likely mediocre . So overall the EA may struggle to generate the strong GDP growth required to start making major inroads into the EA’s continued high unemployment rate and substantial economic slack and hence get a decisive improvement in inflation prospects.
Divided ECB means preferable March easing could slip to June
Despite the above it’s unlikely that the ECB will react quickly with additional easing measures – not least because of the proximity to their market-disappointing December actions and because they will want to assess whether the recent deflationary forces from oil price falls are persistent. So expect dovish words but no action on Thursday: Draghi will likely stress that that the ECB is monitoring the situation carefully and reiterate that “the Governing Council is willing and able to act”. Recalling his 4 December comment about there being “no limits” to monetary policy measures, with the backing of the GC, would be a stroger dovish signal.
And the latest ECB meeting accounts importantly revealed that the ECB haven’t ruled out further rate cuts – indeed the hawks seemed less resistant to that than to tweaks to the APP (QE, which is seen as generating adverse side effects and suffering from decreasing returns). But the ECB doves don’t seem to have really pushed that hard for a 20bp deposit rate cut, preferring to maintain political capital within the ECB and stress that the 10bp (which so disappointed markets) “was also seen as having the advantage of leaving some room for further downward adjustments, should the need arise.” The problem is that going for smaller rate cut can itself make further policy action more necessary e.g. by hitting business/consumer confidence or by stimulating a EUR appreciation. It’s potentially self-defeating and risks undermining ECB credibility.
And the ECB accounts reinforce the picture of a divided ECB – both on growth and inflation prospects and the appropriate policy strategy. On balance developments since the December decisions provides more support for the ECB doves, although the hawks can also draw comfort from some of the data.
In the Accounts the doves cited potential renewed oil price weakness (!) and the consequent hits to consumer/business confidence (plus geopolitical risks), concerns about large slack and weak investment dynamics, worries about the recent record of ECB continually revising down its inflation forecasts (with alternative models producing weaker forecasts) and low inflation breakevens.
ECB hawks focussed on the cyclical recovery proceeding as expected and its resilience to external uncertainties (with an overly-sanguine take on China prospects), “encouraging” core inflation developments, scepticism about the information content of inflation breakevens, concerns that aggressive easing would hit banks’ profits, worries that incentive for fiscal stimulus could be undermined and the need to avoid a “circularity” between monetary policy and market expectations. The latter is obviously fine (Central Banks need to have independent views!), but sits oddly with feeding the buoyant financial market conditions generated by such expectations into their forecast model and then concluding that aggressive policy easing wasn’t required.
Such a divided ECB means that obtaining a consensus for further easing is likely going to take time, and could well require substantial further evidence that things are going awry. So while March is a potential candidate date for easing, given that the updated staff forecasts will extend to 2018 for the first time (and seem likely to again be revised down based upon current conditions), easing could easily slip to June. Indeed, the recent Reuters report about the strong resistance of some ECB members to further easing – “Given the oil price volatility, even if the 2018 forecast is below target, we don’t have to act” – indicates a long battle ahead for ECB doves.
So the ECB communication with the markets in the coming months will be important. But the December experience, where both markets participants and the ECB were burnt and blamed each other for the miscommunication, raises challenges. The ECB may well be less inclined to try and to guide market expectations or Draghi could find less support in doing so. But equally the market may also be more cautious about buying into dovish ECB language (“once bitten twice shy”) which would e.g. make it more difficult for Draghi to talk down any nascent EUR upside generated by the EUR’s risk-off nature. That said, expectations of furter ECB easing have again been growing, with a 10bp rate cut by mid-year now looking to be fully priced (and Draghi will have to be careful not to disturb such expectations if he wants to avoid furter EUR upside).
EUR supported by risk aversion, although it could have been worse for the ECB
Further ECB action should eventually generate EUR downside (to the extent that the EA’s low inflation problem forces the ECB’s hand more than other central banks). And ECB easing expectations have been on the rise again rising, with a further 10bp cut by mid-year now looking to have been priced.
But the complication it that the EUR has been supported by the risk aversion dominating FX markets (because negative interest rates make the EUR a “risk-off” currency). In particular, EURUSD and EURGBP have both traded stronger than implied by short rate differentials, especially the latter probably due to BREXIT concerns reinforcing GBP’s usual “risk on” nature (although it was boosted today by Carney’s dovish leaning, which caused MPC rate hikes to be further priced out and took EURGBP to 12-month highs). But overall EURUSD has remained range-bound, as I expected (see here), and I cautioned that USD upsides could be constrained by China concerns here. But commodity price weakness has also seen EURCAD reach multi-year highs as my long USDCAD recommendation (see here) has also continued to perform. The EUR has also risen versus EM FX.
All this, plus EM and commodity FX weakness, and led to the EUR TWI rising to close to levels which helped prompt dovish ECB rhetoric last Autumn , further adding to the pressure on the ECB to act. But things actually could easily have been worse for the ECB in that there are several signs that the EUR’s risk off characteristics has ameliorated somewhat: (i) EURJPY has declined and by more than implied by sort interest rate differentials, but in line with my mid-October recommendation as the JPY’s safe haven characteristic has shone through in the volatile trading environment (the JPY has been the main winner in this period); (ii) The EUR TWI has risen by less than implied by its previous inverse links with EA equities. And that’s important as the DAX and €stxx have fallen by more than the FTSE or the S&P since December – indeed by a similar ammount to the Shanghai Composite. If the previous links had been maintained the ECB could be facing the daunting prospect of a EUR TWI back around pre-QE levels.
EUR prospects: battle between risk aversion and policy expectations near term
The EUR’s future prospects will be determined by the interplay between policy expectations and market risk aversion. While my bias is that Draghi will come across dovish on Thursday this may be muted given the communication issues discussed above. But the hope is that the ECB hawks will realise that inflation isn’t heading meaningfully up in 2016 and hence soften their resistance and so allow Draghi to work his magic again. But that’s by no means assured. Conversely non-EA monetary policy also looks to have a decidely dovish tinge. Carney’s comments indicate that it may well be the summer at the earliest before the BoE starts even thinking about rate hikes (absent a rebound in wage growth or further inflation upside surprises). And market pricing of a March Fed hike has fallen significantly (Yellen will have an awkward job in her testimony next week given the previously-discussed sharp fall in US breakevens). And we could see dovish innovations from smaller central banks like the Riksbank (the Bank of Canada decision tomorrow could go either way).
So the evolution of risk aversion (market uncerainty) looks set to be the key determinant of where the EUR heads in the near term. And it could go either way and Draghi faces a delicate balancing act in his communication.
• Further negative news from China and/or oil prices could well see risk aversion spike, further supporting the EUR, with the effect amplified if investors start buying more into the secular stagnation story (including a Fed having made a policy mistake). Further global central bank easing would hopefully eventually act as a circuit breaker in such an adverse scenario. But Draghi risks adding fuel to the risk aversion fire in the near term if he comes across as too positive on the EA macro situation or the effectiveness of the existing measures: the largely-priced mid-year ECB rate cut could be challenged.
• Convesely, a dovish Draghi could potentially start calming the situation somewhat – he can impact EUR both via ECB rate expectations and risk appetite channels – if the hawks allow him to give some hope of future ECB giveaways and the markets are receptive to that message (both uncertain). Or the markets could start realising that the sharp market movements have overshot the fundamentals: uncertainty spikes have previously tended to die down after a few months, albeit importantly except during the global financial crisis.
But given the fragile EA recovery, major EUR upsides would likely start triggering valuation concerns – and hence further bring forward ECB easing expectations.
That said, brexit concerns up until the probable summer referrendum seem likely to inhibit significant EURGBP downsides (even if risk factors seem to have been important in the rise), especially with the BoE’s associated dovishness. That’s consistent with the rise in EURGBP risk reversals to multi-month highs, with EURUSD RR’s lagging but EURJPY RR’s down sharply (see Chart). But once the BREXIT uncertaities are resolved, hopefully with a “remain” vote, I’d expect EURGBP to head back down from (late) summer onwards, potentially reinforced by BoE rate hike expectations being brought forward (Q3 2017 looks excessive) and ECB action. Elsewhere EURUSD seems likely to continue range-trading until we get to the key ECB and Fed meetings in March, but with a downward bias. And the near-term risks seem skewed to further EURJPY downside – either because risk aversion spikes further or because Draghi manages to come across dovish on Thursday.