ECB preview: Wonderstuff? Don’t let me down!

The 10 March ECB meeting is shaping up to be make or break for EA prospects and ECB credibility as well as being very important for overall market directions. Deflation has returned to the EA, pipeline inflation pressures are weak and inflation expectations are in the process of de-achoring (with inflation breakevens’ previous links with oil prices, the EUR and equity prices all weakening while US and UK breakevens have stabilised).  EA activity prospects have notably deteriorated and the international environment has significantly darkened. While EA financial conditions have eased slighly in recent weeks that’s due to expected ECB action and so isn’t a reason for ECB timidity.  So the ECB inflation forecasts seem likely to be revised down sharply, at the short end due to lower oil prices (see here) but also further out due to weaker activity prospects and a potential ECB staff rethink on second round effects. An inflation forecast of 1.4%-1.6% in 2018 is thus feasible (if the staff don’t let model mean reversion kick in). And the seriousness of the situation means that the ECB should implement a strong risk-management driven policy easing. Specifically, this optimistic scenario involves a 20bp deposit rate cut, featuring tiered interest rates and another round of TLTROs to protect EA banks’ margins and give them even greater incentive to lend (i.e. credit easing to support thus-far weak investment), a €10-20bn increase in monthly QE purchases (more likely than APP extension given the need to have an immediate impact) potentially accompanied by extending purchases into non-financial corporate bonds and adjustments to the issuer limit, capital key constraint and/or (less likely) removing the prohibition of buying bonds yielding less that the deposit rate. My accompanying post discusses how such ECB over-delivery would likely generate further EA bond market rallies (particularly bunds), limited EUR falls and equity price rises as market risk appetite is supported (making up for the lack of substantive G20 action which I anticipated here),  But there’s also a distinct possibility of disappointment given apparent ECB divisions, worries about adverse side effects of the policies and ECB staff being sanguine about second round effects (with the 2018 inflation forecast then likely around 1.7%-1.8%).  The anticipated QE change is probably most vulnerable, but there’s also a risk that the ECB decides to merely meet market expectations of a 10bp deposit rate cut.  EA financial conditions would re-tighten on such disappointment, with dangerously adverse impacts on inflation and growth prospects.  So the hope is that the ECB has internalised the lessons of the December.  Given this uncertainty, market participants will prefer trades which perform in either scenario.  My accompanying post discusses how short EURJPY and, to a lesser extent, short EURSEK positions are two candidates. 

Hello deflation, my old friend!

Monday’s news that the EA headline inflation dipped back into deflation territory (-0.2% y/y) wasn’t a complete surprise: I argued in January that the renewed oil price weakness would eliminate the positive base effects which the ECB were counting on in December to support inflation (see here).  But there are several further worrying elements: (i) the negative headline print has occured a bit earlier than I anticipated; (ii) deflation is affecting all the main EA members: France -0.1%, Germany -0.2%, Italy -0.3%, Spain -0.9%!; (iii) headline inflation is now weaker than after a year of ECB QE; (iv) core inflation inflation also disappointed, falling back to 0.7% y/y, the weakest since April 2015, while services inflation also continued to slide (the detailed breakdown isn’t yet available).


Moreover, EA pipeline inflation pressures continue to look weak: (i) poducer price inflation remains moribund; (ii) import price inflation has continued to be susprisingly-weak despite the euro’s previous depreciation – perhaps reflected international factors like persistently-negative Chinese producer price inflation – and indeed faces downward pressure from the recent bout of euro strength; (iii) the ECB seem to have been susprised by the continued weakness of wage growth, with Draghi now openly-worrying about second-round effects from lowflation, although I’ve been arguing since last summer that the continued high unemployment should make this the central case (see here and here).

Inflation breakevens becoming even more worrying

And if that weren’t all bad enough, inflation expectations teeter dangerously close to deanchoring, putting at risk ECB credibility (which the ECB have finally started worrying seriously about).  Specifically, I’ve been arguing since last summer that the ECB should be getting very concerned about the precipitous fall in the key 5y5y inflation breakevens (see here and here), initially apparently driven by oil price declines. The situation has deteriorated further in recent weeks, with 5y5y breakevens hitting a fresh record low of 1.37%, appearing inconsistent with the ECB’s goal of “close to but below 2%”. Indeed, those fresh look more like genuine declines in inflation expecations and are even more concerning because they have occurred despite: (i) Draghi’s fresh dovish comments– his power to affect inflation expectations via mere words seems to be waning, with action instead required; (iii) oil prices having stabilised (bounced slightly)- the previous close link has weakned as the focus has shifted more to ECB credibility; (ii) the EUR having fallen back a little – the previous relatively close link between EUR appreciation (and implicitly import price weakness) and lower breakevens has also broken down;  (iv) EZ equity prices having bounced a little – so the latest fall doesn’t look to have been driven by risk premia effects; (v) US inflation breakevens having bounced back a little (although the Fed still look concerned) and UK breakevens having stabilised – again arguing against a general risk premia explanation for the EA fall and suggesting that there’s something specific going on with ECB credibility.


Surveys also paint a pretty dire picture on EA inflation expectations: (i) PMI price balances point to firm downside price pressures, with the February manufactfacturing balance being the weakest in nearly three years; (ii) the EC industrial condidence survey similarly features fresh declines in price expectations; (iii) the EC consumer confidence survey points to very subdued price expectations, and hence the potential for second round effects in wage; (iii) the March 2016 ECB survey of professional forecasters (SPF) indicates shows that the ECB isn’t believe to be able to hit it’s inflation objective, with 2018 HICP expectations only running at 1.6% (the same as the ECB’s 2017 forecast from December).

Slide3  Slide4

So overall Draghi’s 1 February concern about inflation expectations and second round effects eventuating seems apposite: “While the most recent wave of disinflation is mainly due to the renewed sharp fall in oil prices,weaker than anticipated growth in wages together with declining inflation expectations call for careful analysis of the channels by which surprises to realised inflation may influence future price and wage-setting in our economy”. And he’s right to stress that a “wait and see” approach carries substantial risks, although it’s not yet obvious that he’s managed to get the rest of the Governing Council on board.

Indeed, high and rising public debt to GDP ratios (except in Germany) mean make deflation expecially dangerous for the EA: debt deflation would be extremely difficult to get out of.  The positive note here is that most peripheral bond yields have been flat in recent months, with the notable exception of Portugal given political uncertainty, doubts about adherence to fiscal consolidation plans and structural weaknesses (see here). That said, peripheral bonds also haven’t shared the continued bund rally in anticipation of further ECB action, which has has seen 10-year yields appproach the April 2015 lows and rates right out to 9-years fall below the ECB’s -0.3% deposit rate, so peripheral-bund spreads have risen.

Slide12  Slide16

Activity Picture Also Worrying: weak confidence, foreign exposures, credit easing required

Furthermore, the EA activity picture is also worrysome: (i) PMIs have fallen back notably across EA members (e.g. German manufacturing at a 15 month low), with the forward-looking new orders/business balances also importantly declining on weak export marketseakened; (ii) last week’s EC surveys worryingy showed highlighted declines in EA eonomic sentiment, business climate, industrial confidence, services sentiment and consumer confidence (!); (iii) The German IFO business climate has fallen sharply, with the expectations component at a 4-year low, while the ZEW survey paints a similar downbeat picture; (iv) EA industrial production growth has turned negative (-1.3% y/y in December), with most of the country series also turning negative or down (Germany -2.3% y/y). I highlighted Germany’s relatively-high exposure to the slowing Asian region last summer (see here); (v) EA retail sales growth has fallen back, likely reflecting weak consumer confidence and weak wage growth (although employment has been stronger).


The ECB has long-trumpeted the decline in corporate borrowing rates, together with a compression of peripheral spreads, as substantial win from it’s policies (which Draghi talked up in December and January “we can do more because the policy is working“).  But I’ve long believed that weak corporate credit demand, in part due to continued high debt levels, would constrain lending growth (see here). So I haven’t been surprised at continued weak corporate  lending growth (a measly 0.6% y/y, from a low base) and investment continuing to represent the missing link in a sustained EA recovery (along with net exports not kicking in). And this weakness suggests that further credit easing (a fresh round of TLTROs) is required.  The recent travails of the EA banking sector, triggered by concerns about the impact of negative ECB desposit rates on banks’ profit margins, adds to concerns from the supply side generated by still-high NPL ratios in countries such as Italy, and this calls for counterveiling measures by the ECB next week.

Slide7  Slide8

Financial conditions: some respite, but not a reason for ECB to be timid

One potential bright spot is that financial conditions have eased a little in recent weeks since my previous post. In particular: (i) The EUR TWI has fallen by over 2%, although it remains elevated; (ii) bond yields have been flat to falling (in Germany); (iii) lower nominal rates also mean that EA real interest rates haven’t risen despite the previously-discussed sharp fall in inflation breakevens, although again they remain substantially above their spring-2015 levels; (iv) EA equities, including bank stocks, have bounced a little from their


But this easing in financial conditions isn’t a reason for ECB timidity, even if it pulls up the ECB inflation forecasts a little given their impact on the conditioning assumptions.  The reason is simply that the easing largely reflects the increased expectations of further ECB easing (my accompanying POST illustrates that recent EURUSD movements have been highly correlated with Bund-Treasury yield differentials). So rather as I argued before the December ECB disappointment (see here) financial conditions would likely re-tighten sharply should the ECB disappoint.  That would pile on the pressure, so the ECB needs to be careful in interpreting the staff inflation forecasts.

What can (will) the ECB do? Will Draghi push through on his “no limits” promise

Given this parlous state of affairs it’s important than the ECB gets ahead of the curve (market expectations) if it’s going to shake the EA out of the doldrums. Indeed, given the situation there’s a strong argument for taking out insurance by doing more than the central case suggests i.e. a risk management dovish policy innovation. And Draghi yesterday re-iterated that the ECB has “a variety of instruments at its disposal” and that “there are no limits to how far we are willing to deploy our instruments within our mandate to achieve our objective” (see here).

The updated ECB staff inflation forecasts will play an important role in driving any policy changes, and will importantly include forecasts for 2018 for the first time.  And even the Weidmann has acknowledged that these are likely to be revised down from their overly-optimistic December forecasts, which anticipated inflation at 1.0% in 2016 and 1.6% in 2017.  As I discussed here the sharp oil price fall, down 20% from the previous forecast cut-off date despite the recent stabilisation, should generate substantial falls in the near-term forecast as the previoiusly-anticipated positive base effects are eliminated.  Weaker domestic and international prospects should see downward revsions further out. this e  dominate revisions  Draghi has promised also flagged that ECB staff will There’s uncertainty here about

But several factors mean that there’s a distinct possibility that the ECB again disappoints (causing renewed EUR strength, further falls in inflation breakevens, equity weakness and a potential bond market sell-off):
• Market expectations are already quite high e.g. at least a 10bp depo rate cut is priced.
• Recent Governing Council divisions might persist. Draghi’s comment that the GC unanimously supported the key sentence “It will therefore be necessary to review and possibly reconsider our monetary policy stance at our next meeting in early March” is very different from them all actually agreeing to a step change in the policy response rather than another disappointing “recalibration”. And Weidmann has prominently critiqued discussions of further aggressive easing, e.g. arguing that the ECB should look through short-term oil-price driven inflation fluctuations, although he isn’t voting next week.
• Some of the possible measures have potential adverse side-effects. Deposit rate cuts can hurt EA banks’ margins and hence squeeze lending flows: Weidmann also recently argued that any measures mustn’t be counterproductive in this way. Worries also persist that extra QE (APP) can reduce reform incentives and risks getting dangerously close to monetary financing of public debt.
• There’s a growing concern within the GC that monetary policy is being asked to do too much in the face of insufficient fiscal support or structural reforms by the EA member states. That said, Draghi have argued several times that “we do not surrender“.
• ECB members worry that they risk being bossed around by the markets, by being forced to act by adverse market developments (oil prices, inflation breakevens, EUR, equity prices). But thus far the markets seem to have been beter judges of economic fundamentals than the ECB’s overly-optimistic mean-reverting forecasts (which will hopefully receive a fundamental rethink rather than just turning the handle).
Technical constraints face some measures, most notably that QE purchases are getting more difficult with more EA bond yields falling below the (current) ECB deposit rate.

Overall it’s a tough call about whether the ECB will manage to surprise positively or ends up disappointing again. My rational side reasons that with the situtation so serious the ECB will shift into risk-management mode and thereby over-deliver to make sure that they haven’t got to come back again in a few months with their credibility further damaged.  This scenario would involve (in decreasing probabilities of occurring):
A 20bp deposit rate cut (to -0.5%). The market is already pricing at least 10bp cut and the ECB really needs to exceed expectations if it’s going to steepen the yield curve (whose flatness is currently suggesting recession risks) and put downward pressure on the EUR.
Tiered interest rate arrangements and a fresh round of TLTROs.  The former protect EA banks from the adverse margin impact of lower rates. Constancio provided a strong hint about interest rate tiering on 19 February: “In looking to what can be done if we decide to ease further, we’ll have to mitigate the effect on banks as other countries have done“. A fresh round of TLTROs (i.e. credit easing) aims to provide banks with yet further incentives to lend in order to transition out of disappinting lending dybamics and give disappointing fixed investment a boost. So their terms can be expected to be quite generous.
• An increase in monthly QE (APP) purchases from €60bn to €70-80bn a month. The sticking point is greater GC resistance, plus bond yields are already low. But the ECB will want to avoid any upward pressure, plus help narrow peripheral bond spreads and support inflation expecations. But this seems likely to have more immediate impact than an APP extension – bond sold off following the December 6-month extension APP extension (to March 2017) and the reinvestment of principal of maturing bonds (worth €680bn) – although I wouldn’t completely rule that out if they can’t address the bond supply issues.
• But loosening the issue/issuer share limit (non-CAC bonds) and/or the capital key constraint (country share limit) can loosen those constraints. The former is more likely than the latter given worries about supporting fiscally weaker countries. That said, in January Draghi hinted at flexibility here “…if there were constraints of any kind we’ll have technical work making sure that we can use all the instruments up to their full availability.”
Expanding the APP into other assets such as non-financial corporate bonds is a further possibility, even if the supply remains limited.  Draghi recently confirmed that suitably-rated non-performing loan portfolios could be accepted as ECB collateral, while denying any direct dicussions with the Italian authorities.
Loosening the lower interest rate APP constraint, which bars purchases of bonds with yields less than the deposit rate (currently -0.3%), would also make APP operations easier. But this seems unlikely given that the constraint aims to prevent automatic Eurosystem losses on APP.  And a 20bp deposit rate cut would in any case help out here. I argued here that this constraint/scarcity effect, suggested EA yield curve flattener trades as APP purchased are pushed to longer maturities (bunds out to 9 years now yields less than -0.3%).

Market Impacts

My accompanying post discusses how such ECB over-delivery would likely generate further EA bond market rallies (particularly bunds), limited EUR falls (given it’s continued funding curreny nature) and equity price rises as market risk appetite is supported a little (partly making up for the lack of substantive G20 action which I anticipated here).  Conversely, EA financial conditions would re-tighten on ECB disappointment, which seems most likely on the QE side of things, with dangerously adverse impacts on inflation and growth prospects. Given this uncertainty, market participants will prefer trades which perform in either scenario.  My accompanying post discusses how short EURJPY and, to a lesser extent, short EURSEK positions are two candidates.











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