ECB preview: Awaiting the credit easing bazooka but several dark clouds persist

This post dissects the Euro Area macro-financial and policy situation in advance of the 2 June ECB meeting. The main points are:

  • Draghi will likely focus on the positive prospective effects of their imminent credit bazookas (TLTRO II and CSPP) including highlighting the positive anticipatory impact of CSPP on bond issuance and spreads. That said, the former is as-yet nothing special and the initial impact on the latter has unwound a little.
  • He’ll probably also announce that Greek bonds can be used as collateral for ECB loans, but won’t be eligible for QE.
  • The ECB staff GDP and inflation forecasts will likely be revised up, given March’s ECB credit easing and QE extension plus recent higher oil prices. But the inflation forecasts could neverthless remain below 2% in 2018, potentially helping rationalise the GC’s recent distancing of themselves from the staff forecasts.
  • But Draghi will likely re-iterate that the risks remain to the downside, given continuing international (China and emerging market) risks, and that inflation will likely remain low near term.
  • Near-term EA growth seems likely to slow from the four-year high in of 0.5% q/q in Q1, which was supported by several one-off factors.  Surveys point to only 0.3% growth in Q2, with likely periphery underperformance.  Indeed, consumer confidence and investment intentions are flat-to-falling (even in Germany), corporate bank borrowing is only picking up slowly and corporate credit demand to fund investment remains subdued (although Draghi will likely be more positive).
  • The ECB staff wage growth forecasts could well be cut, despite better employment growth: EA unemployment remains painfully high, surveys don’t suggest any hiring acceleration, the EA Phillips curve is flat and ECB staff have been serially over-optimistic on wages.
  • Indeed, Draghi will likely reiterate worries about potential second round effects from continued low inflation on wages and the continued low market-based inflation expectations despite oil price rises and contrary to equivalent US developments. But market-implied deflation probabilities have fallen significantly.
  • Draghi will likely continue to raise the rhetoric on the need for fiscal policies and structural reforms to complement the ECB’s monetary measures (see here).
  • The euro’s recent limited retracement from it’s post-March gains, on renewed Fed hawkish comments and reduced Brexit probabilities, helps EA growth and inflation prospects and could extend further. But substantial euro weakness seems unlikely despite strong net portfolio investment outflows and isn’t the ECB’s focus.
  • Overall, the ECB will be in “observe and analyse” mode around the impact of their latest easing measures (implemented imminently) until at least the Autumn. I’ll be watching whether TLTRO II, with it’s exceptionally-generous terms, feeds into increased lending (I remain sceptical) or instead funds carry trades in government bonds.
  • I’m sympathetic to market pricing the risks being skewed to eventual further ECB action, but expect Draghi to firmly rebuff any such suggestions on 2 June.

Draghi to stress positives of credit bazooka and positive Greek news but potential criticism of governments 

Given that the March credit easing measures will only start being implemented in June, next week’s ECB press conference is unlikely to feature fireworks despite updated staff forecasts being presented. Rather, it’s likely to feature Draghi  focussing on the positive prospective effects of  TLTRO II and CSPP.  Indeed, he’ll likely argue that CSPP has already had positive impacts ahead of it’s launch. First, corporate bond spreads remain lower than prior to March announcements, although some of the initial announcement effect has subsequently unwound (see Chart).  Second, corporate bond issuance picked up in March after a few months of net redemptions, although the uptick isn’t that large (more timely ECB data would definitely be helpful here).


The terms of TLTRO II are exceptionally-generous – effectively subsidising borrowing at the ECB deposit rate (-0.4%) is very forgiving lending targets are hit – so a large uptake should be expected. But the deeper question remains of whether such fresh liquidity funds lending to the real economy, in an environment of not-great credit demand (see below). I suspect that a reasonable proportion will instead be used to fund financial market trades e.g. government bond purchases, thereby reinforcing the ECB’s QE purchases.

So it’s likely that the ECB staff GDP and inflation forecasts will be revised up when they incorporate the imminent credit bazooka and QE extension, plus the recent oil price rise (the March forecasts were conditioned on oil prices rising from $35 in 2016 to $45 in 2018, substantially below recent oil futures). That said, media reports after the March meeting indicated that the fresh measures would add only 0.2pp to the inflation forecasts i.e. a relatively-disappointing bang for the euro. I’m doubtful about such small effects, but interestingly the latest ECB meeting account (minutes) seemed to disassociate the Governing Council from the staff forecasts: “The medium-term horizon should not be equated to the horizon of the staff projections, as outside observers sometimes appeared to do when characterizing the Governing Council’s reaction function…avoid conveying the sense that monetary policy was mechanically focused on a specific time horizon.” The aim could be to defuse discussion of potential further easing ECB easing if the updated staff forecasts show HICP struggling to hit 2%: the March staff forecasts saw inflation at only 1.6% in 2018.

Moreover, Draghi seems likely to re-iterate that the risks remain to the downside, if perhaps less than in March, given continuing international risks: Tuesday’s ECB FSR stressed China and emerging market risks.  Moreover, the message that inflation will likely remain low over the next few months will likely be repeated (although higher oil prices ), not least because that also helps diffuse discussions of further easing.

The other positive is that Draghi will probably announce that Greek bonds can be used as collateral for ECB lending operations, given this weeks’ creditor agreement. That said, Draghi could conceivably hint that he’d have preferred debt relief to be sorted out now rather than deferred until after the German and French elections. Moreover, Greek bonds unfortunately won’t immediately be eligible for the ECB’s QE purchases, given that the existing holdings from the 2010 Securities Market Programme exceed the ECB threshold.

Finally, the press conference will also likely see Draghi continue the recent elevated ECB frustration at the lack of use of available fiscal space and structural reforms to complement the ECB’s herculean, if tardy, monetary easing measures.  Preat’s recent ‘monetary policy can’t do it alone’ interview  was pretty critical of German policy.  And the latest ECB meeting account provocatively noted that “It was to be regretted that these very detailed, country-specific recommendations were not being sufficiently followed up and implemented….More product market reforms could be considered the highest priority at the current juncture….strongly reiterated the need for other policy areas to contribute much more decisively, both at the national and European levels”. Strong stuff indeed, which Draghi is bound to get asked about.  I’m intending on examining these issues in more detail in a forthcoming post – focussing on the inter-related factors or weak demand, high debt levels, excess savings and record current account surpluses being a weakness rather than a strength. But the remainder of this post considers a number of important shorter-term developments.

Decent Q1 growth seems unlikely to persist

The main positive is that Euro Area GDP grew 0.5% q/q in Q1, the strongest since Q1 2011 (see left-hand chart below), albeit revised down from the preliminary 0.6% estimate.  While sectoral details are not yet available, country data imply that the growth was again supported by domestic demand, with exports continuing to drag.  Indeed, the relatively-robust Q1 German GDP growth – rising 0.7% q/q, the strongest for two years (see right-hand Chart) – was importantly driven by an uptick in fixed investment (rising 1.9% q/q) alongside continued moderate consumption growth and net exports subtracting only 0.1pp from growth.  Unfortunately, there’s several reasons for not getting carried away with this Q1 performance. Rather, there’s strong reasons to think that growth will fall back in Q2.


First, strong Q1 growth was likely supported by several one-off factors which seem likely to reverse into Q2.  In particular, strong Q1 French consumption (1.2% q/q) seems like a one-off bounceback from Q4’s surprisingly weak -0.1% which was driven by spending being delayed in the aftermath of the Paris attacks.  And the Q1 strength of German fixed investment was importantly affected by buoyant construction investment (up 2.3%) as the mild Q1 weather allowed projects to be completed. Hence Q2 may well be commensurately weaker.

Surveys also point to a Q2 slowdown, with likely (continuing) periphery underperformance. In particular, the latest batch of euro area PMI surveys were fairly uninspiring, with the EA composite EA PMI fell to the lowest since January 2015 (see Chart below), although it hasn’t fallen off a cliff.  But forward-looking components were also weak and overall the PMIs imply only 0.3% Q2 EA GDP growth, down from Q1’s 0.5%.


That EA weakness occurred despite the German and French PMIs actually rising somewhat. And relative German strength was confirmed in this week’s IFO survey, with current conditions rising to an 8-month high and expectations component rising to 5-month high (see chart above), although the the ZEW German investor survey forward-looking component actually retraced. But overall, the emerging picture seems be of core outperformance and periphery under-performance.  Indeed, it’s notable that Spanish and Portuguese GDP growth slowed  little in Q1, in contrast to the overall EA improvement (see chart below).


Investment intentions show no signs of picking up, even in Germany 

Turning to demand components, it’s also notable that there doesn’t seem to have been any major rise in corporate fixed investment intentions. This is important because weak fixed investment has been, until recently in Germany, a significant lacking element of a sustainable EA recovery (I’ve been arguing this since last YEAR).  Specifically, the latest semi-annual EC survey indicates that it’s a flat-lining fixed investment picture at the EA level, with indeed German and French 2016 investment plans being slightly below their 2015 equivalents. Conversely, while Italian and Spanish investment plans are up from their weak 2015 levels they remain fairly modest. But hard data on German domestic capital goods orders also suggest that the recent strength of German fixed investment in Q1 probably won’t be matched in Q2: the annual growth rate of -7.5% was the weakest since mid-2012 (see chart below).


Moreover, the latest ECB bank lending survey reports a fall  in loan demand to fund for fixed investment, with indeed only debt restructuring demand reporting higher loan demand (see Chart).  That said, the ECB have tended to view these data in a more positive light so I wouldn’t again be surprised if Draghi stressed the positives.  But what can’t be disputed is that actual corporate bank loan demand is improving only glacially: the 1.1% y/y growth reported in March (see Chart) doesn’t suggest any capex splurge, although as noted above bond issuance did pick up a bit apparently in response to the ECB’s CSPP announcement. But it’s also notable that the limited uptick in corporate bank lending seems driven by France and Germany, with growth falling back Italy, Spain and Portugal. The previously-discussed core-periphery divergence is also showing signs of appearing in corporate bank lending.


Of course, the ECB credit easing bazooka (TLTRO II) aims to turn things around here, by offering exceptionally-attractive lending terms for hitting low lending targets. But, as discussed above, there’s a reasonable chance that much of it could end up funding financial market trades rather than bank lending to the real economy. That will of course also provide stimulus – e.g. banks purchasing government bonds will reinforce ECB QE – but it will also have a less direct supportive real-economy impacts, which is what really needs sorting out for sustainable growth and acceptable inflation to return to the euro area.

Consumer confidence flatlining

Alongside this, consumer confidence has yet to improve significantly, despite somewhat better employment numbers (see below) and the previous fall in the oil price.  So questions remain about whether consumption growth will improve, although the ECB accounts are correct to point out that stable household savings indicate that income gains from lower oil prices have been spent. At an EA-wide level overall consumer confidence remains below early-2015 levels, consumers have become increasingly concerned about the future economic situation and their worries about future unemployment remain elevated (see Chart). Moreover, consumer confidence has been flat to falling in all the major EA countries (see Chart). Yesterday’s GfK German consumer confidence release was more positive (see here), unsurprisingly given the more buoyant German economy. But even here the fall-back in German consumers’ price expectations could well worry the ECB: at an EA-wide level consumers’ price expectations have recently remained flat at low levels.


Employment improves but second round effects greater risk than upward wage pressure 

Another positive of recent months has been the continued slow improvement in EA employment and unemployment decline.  Indeed, Governing Council members have trumpeted the 1.2% y/y employment rise (see Chart) for being the strongest since 2008. And in theory that should help support consumption growth.  While a promising sign, big picture the employment growth remains unspectacular (substantially slower than in the UK until recently and only half the EA figure in mid-2000). So there’s only been relatively slow and small inroads into the high EA unemployment problem – the latest 10.2% rate is less than 2pp lower than the peak nearly three years ago (see Chart) whereas the UK unemployment rate fell by 3pp over the same period from a substantially-lower start point.



Moreover, surveys of corporate hiring intentions haven’t really improved (see Chart above). Rather it’s a picture of flat-lining for the EA as a whole, but with hiring intentions actually retracing in France, Spain and Portugal.  This implies little basis for expecting employment growth to accelerate substantially, even if the surveys seem to have under-predicted the recent employment improvement.


But more importantly, the actual wage pressure essential to support domestic inflationary pressure remains a distant prospect. Euro area compensation per employee grew only 1.3% y/y in Q4 2015, down from 1.7% two years earlier.  This isn’t particularly surprising given the continued high EA unemployment and the very flat EA Phillips curve (see Chart, which is part of a global trend e.g. I provided some US evidence last September and this morning XpertHR reported a fallback in UK pay settlements).  This implies that even in the unlikely event of EA unemployment falling sharply we’re unlikely to get a significant rise in EA wage growth to generate the decent domestic inflationary pressure necessary for the ECB to achieve it’s goal.

Slide22  Slide21

Indeed, the ECB recently admitted that they have been serially over-optimistic in continuing to expect a rise in wages growth.  The chart above illustrates that the ECB staff forecasts since early 2014 of wage growth gradually rising above 2% have been continually disappointed, with compensation per employee instead heading down to only 1.3% in Q4 2015.  The ECB explanation for the disappointingly-low wage growth mainly is pretty mainstream and unsurprising: it’s mainly attributed to high labour market slack, with low inflation playing a secondary role and low productivity making a minor contribution (see Chart below).


Moreover, the March ECB staff forecast nevertheless again forecast a reasonable uptick in wage pressures – compensation per employee rising to 1.9% in 2017 and 2.1% in 2018 – on the back of reduced labour market slack and a pick up in inflation (towards the end of the projection horizon) but held back by continued weak productivity growth.  My own forecasts are a bit lower – based upon my simple Phillips curve evidence, the previous forecasting performance and continued low inflation (headline falling back to -0.2%, core at only 0.7%, with Draghi warning of further falls in the coming months).  So I’d expect the upated ECB staff wage forecasts to be revised down a little (perhaps around 20bp) at the 2 June ECB meeting, even if the overall GDP and inflation forecasts are revised up given fresh ECB easing measures and the oil price rise.

Indeed, the ECB have become increasingly concerned about second round effects, from persistently-low inflation to low wage bargaining, starting to operate. Specifically, The latest ECB meeting account (minutes) put quite significant stress on this: “while euro area inflation was expected to pick up, it was crucial to ensure that the very low inflation environment did not become entrenched via second-round effects on wage and price setting“. They also opined that such adverse dynamics could potentially be starting to operate in low wage-growth economies, without naming them. But the Chart below illustrates that while German and Dutch wage growth looks respectable, that’s far from true in Italy and Spain and perhaps even Belgium.  Of course, HICP inflation also varies across EA members: Spain’s -1.2% y/y figure compares with the EA’s aggregate of -0.2% and Germany’s -0.3%.  So the ECB is right to be on the lookout here, especially given flat Phillips curves.


 Inflation breakevens rightly concerning ECB again


For a few months the ECB has seemed to be downplay the significance of the continued low levels of Euro Area 5y5y inflation breakevens, which had previously been the touchstone of the need for ECB action in the wake of Draghi’s Jackson Hole speech. But I’ve nevertheless continued to stress their continued amber warning signal in recent months: it’s been frustrating that journalists haven’t really put Draghi on the spot at ECB press conferences.

But the latest ECB accounts (minutes) revealed that the ECB share my concerns, noting that “It was also considered worrisome that, despite the stabilisation in oil prices, market-based inflation expectations had not picked up from their low levels…While in principle a decoupling of inflation expectations from oil-price developments was welcome, in the current context this was a matter of concern.” So the continued low levels of inflation breakevens in the weeks since the previous ECB meeting (see Chart), despite further oil price rises (above $50 today) should add to the ECB’s concerns.  Indeed, at first sight markets do seem to be questioning the efficacy of the fresh ECB’s measures announced in March in raising EA inflation, although the credit easing measures will actually only start being implemented in the coming weeks.


The standard caveat about inflation breakevens is that they’re not “pure” measures of market inflation expectations – they contain risk, liquidity and term premia.  But the fact that the equivalent US inflation breakevens have risen notably from their March lows (see Chart above) downplays such market-factor explanations and hence should add to ECB concerns that the market is questioning it’s credibility.  Indeed, the latest ECB accounts note that “there was a need to counter the perception that monetary policy could no long contribute to a return of inflation to the Governing Council’s aim of below, but close to, 2 percent”.

The ECB can, however, take come comfort from the fact, despite continued low inflation breakevens, inflation floors indicate that the market is pricing in a substantially-smaller probability of deflation than it was at the start of 2016 (see chart below).  But the ECB may regard that as the minimum they’d hoped to achieve with all their monetary policy bazooka.


Fed hawkishness and reduced Brexit probabilities relieve some of euro strength, but don’t expect significant falls 

The euro’s appreciation after Draghi’s March press conference comments apparently ruling out further ECB rate cuts (see here) largely persisted despite Draghi becoming less definitive in April (see Chart).  While the ECB’s focus has shifted towards domestic considerations, such euro strength is not particularly helpful – it adds to disinflationary pressures and crimps export prospects.  But the Fed’s recent more hawkish stance (which I anticipated could occur here) and apparently-reduced odds of Brexit have taken a little of the pressure off the ECB.


On the Fed impact, the chart above illustrates that EURUSD traded closely in line with 10-year Bund-Tresury differentials right up until the March press conference and Draghi’s comment.  But recent Fed hawkishness, most notably in last week’s FOMC minutes and followed up by an array of Fed Governors re-iterating that June is a live meeting, has seen EURUSD falling from around 1.15 to below 1.12 thereby closing the gap to relative yields. And, if US data keep co-operating, further moves in this direction seem likely in advance of the 14-15 FOMC meeting. While market-implied probabilities of Fed rate hikes have risen significantly in recent days,  the chance of a July hike remains only a little above 50% and June is lower. Indeed Yellen’s forthcoming speeches (on 27 May and, especially, 6 June) could shift the dial further, although the only major US data point before the June meeting is the US labour market report while waiting until July would give the Fed further inflation reads. That said, the FX market appears fairly tired of the policy divergence theme – the overall limited USD moves on recent Fed hawkishness look more like marking to market – so I’m not expecting EURUSD to plummet near-term.

Betting market Brexit odds have recently fallen to 20%, from a peak of over 40% in mid-March and around 30% in early May, as the “remain” arguments about the likely substantial economic costs of Brexit seem to have hit home. And EURGBP has fallen roughly in line with this turnaround (see Chart below).  Unfortunately it’s premature to conclude that the “remain” lead is unassailable: e.g. yesterday’s YouGov poll points to a dead heat (41% each) whereas last week it had had “remain” 4 points ahead. And immigration-related issues could yet become more important. But market participants seem to think that at-present undecided voters will eventually plump for the status quo, following the Scottish referendum pattern (although near-term GBP implied volatility also then spiked sharply).


Of course, predictions of substantial euro weakness have a long-history of proving costly – e.g. many high-profile EURUSD parity predictions were quickly withdrawn a few months ago – and such painful memories likely raise the bar for substantial euro falls from here in an FX market apparently reluctant to bet on the policy divergence theme.  So the recent picture of very strong net portfolio capital outflows (see Chart above), driven by foreigners selling low-yielding EA debt instruments and EA residents buying higher-yielding foreign debt instruments, could well be ignored.






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