Investment Research General Market Conditions 27 August 2015 ECB preview Dovish and slightly worried Main focus on the drop in 5Y5Y inflation expectations that are again far below the ECB s 2%-target The lower oil price and stronger EUR are threatening the ECB s outlook for higher inflation Core inflation has jumped recently but there is a looming risk of indirect effects of the lower oil price The ECB is likely to express concern about spill-over effects from weakness in China and the equity sell-off Domestic demand is still looking to strengthen but any downside risk will be monitored closely See the five charts illustrating why we expect the ECB to express a dovish stance See the five charts we believe the ECB will consider before stepping up its easing A dovish twist already in the introductory statement Overall we expect the ECB to sound dovish and slightly worried at its upcoming meeting on 3 September. The lower oil price together with the stronger effective EUR are challenging the ECB s outlook for a sustained adjustment in inflation and, looking at the 5Y5Y inflation-linked swap rate, inflation expectations do not seem well anchored. Already in the introductory statement we expect a more dovish tone from Draghi. Firstly, we expect him to include a sentence emphasising the open-endedness of the QE programme and secondly, we believe he will add that the ECB is ready to use all available instruments if needed. Moreover, Draghi is likely to put a lot more focus on the downside risks to the economic outlook following the latest developments in China together with the sell-off in equities. ECB's updated projections will be too optimistic when released Source: ECB, Eurostat, Danske Bank Markets Senior Analyst Pernille Bomholdt Henneberg +45 30 51 53 75 perni@uk.danskebank.com Important disclosures and certifications are contained from page 8 of this report. www.danskeresearch.com
Currently, we see a low probability of the ECB delivering imminent easing and we believe the ECB will first attempt to improve the inflation outlook by verbal intervention. Related to this we have listed five factors including core inflation and activity figures, which we believe the ECB will monitor closely and which in our view need to start to deteriorate before the ECB decides to ease further (see below). If some of these factors start to worsen, we expect the ECB to step up its easing. In that case we view it as most likely that the ECB will extend the QE programme beyond September 2016, although it is also possible that it scales up the monthly asset purchases as the summer front-loading has shown that the programme implementation is flexible. The market is increasingly speculating on the ECB increasing its asset purchases and the theme is likely to continue based on a dovish stance from the ECB. The ECB s inflation projection for 2017 could be crucial for how the market reads the ECB. We expect a slightly lower forecast for 2017, mainly driven by the lower oil price. However, the updated projections are based on a cut-off date in mid-august, hence they do not include the latest decline in the oil price and the strengthening of the EUR, implying they are too optimistic when released. Consequently, even if the ECB ends up being less dovish than the market expects, speculation about more easing could soon return. Five charts illustrating why the ECB will express a dovish stance Intensified currency war implies stronger effective EUR, which is a headwind to inflation The ECB s outlook for higher inflation is threatened by a renewed trend higher in the effective EUR, which, when considering the 3M change, is at the highest rate in more than two years. The upward pressure on the EUR has strengthened after People s Bank of China has joined the global currency war and together with an expected later lift-off from the Fed, there is pressure on the ECB to express a dovish stance with the aim of weakening the exchange rate. Note that the ECB s new inflation projection will not include the latest strengthening of the EUR in the second half of August and overall the exchange rates will not change the updated forecast for inflation significantly. The stronger effective EUR is a headwind to inflation Source: Bloomberg, ECB, Danske Bank Markets 2 27 August 2015 www.danskeresearch.com
The lower oil price challenges the ECB s outlook for a sustained inflation path The oil price has declined considerably since the ECB published its latest inflation projections in June and the sharp drop clearly increases the risk of a new period of deflation in the euro area. In addition, the Brent forward curve, which the ECB uses as input in its projections, is pricing a much lower oil price in 2016-17 implying the ECB s outlook for a sustained adjustment in inflation in the medium term is under threat. On the other hand, the lower oil price also has some reflationary effects as it eventually supports wage pressure by strengthening domestic demand through higher consumers purchasing power. The lower oil price challenges the ECB s outlook for a sustained inflation path Source: Bloomberg, ECB, Eurostat, Danske Bank Markets A sharp drop in 5Y5Y inflation expectations have taken it far below the ECB s 2%-target A drop close to 1.60% in the 5Y5Y inflation-linked swap rate will in our view imply a dovish stance from the ECB as it shows de-anchored inflation expectations. A year ago, when the 5Y5Y inflation swap dropped below 2.0%, Draghi drew market participants attention to this medium-term inflation measure and made it clear that it is monitored at the ECB. We believe the reversal of the slight upward trend following the announcement of its QE programme in January dissatisfies the ECB but the lower expectations are also related to the drop in the oil price and hawkish ECB members could argue that the inflation swap market is still suffering from a bit of poor summer liquidity. Drop in 5Y5Y inflation expectations have taken it far below the ECB s 2%-target Source: Bloomberg, ECB, Danske Bank Markets 3 27 August 2015 www.danskeresearch.com
Higher real rates could be seen as an unwarranted tightening of the monetary policy Real interest rates are increasing as the lower inflation expectations dominate the downtrend in nominal yields. The ECB is likely to see this as an unwarranted tightening of the monetary policy and this is one of the factors that could lead to further monetary policy easing. However, again, the decline in inflation expectations is likely to be seen in light of the lower oil price, implying the ECB will stick to a dovish stance and not yet signal imminent easing. Higher real rates could be seen as an unwarranted tightening of the monetary policy Source: Bloomberg, Danske Bank Markets Uncertainty about China and the global equity sell-off increase downside risk to growth outlook The weakness in the Chinese economy increases the downside risk to the ECB s expectations that the recovery will broaden further. However, it is probably still too early for the ECB to determine the impact and for now we expect the ECB to sound a bit worried. This should especially follow as the weakness could spill over to weaker euro area sentiment. In the current recovery investments have remained relatively subdued and the renewed uncertainty is likely to imply a continued cautious stance among businesses especially in an environment where stocks decline. Uncertainty about China and the global equity sell-off rise downside risk to growth Source: Markit PMI, Danske Bank Markets 4 27 August 2015 www.danskeresearch.com
Five charts illustrating what the ECB is likely to consider before stepping up its monetary easing Core inflation has jumped but the low oil price might have indirect and second-round effects Core inflation has jumped from the historical low of 0.6% in April to 1.0% in August and is broadly in line with the ECB s June projections but there is a risk of a renewed downtrend due to indirect and/or second-round effects of the lower oil price. We see the biggest downside risk to core inflation in 2016, where base effects will be less supportive. Particularly the ECB s core inflation forecast for 2016 looks optimistic in our view and a lowering of this could imply the ECB will extend its QE purchases beyond September 2016. Core inflation has jumped but the low oil price might have indirect effects Source: ECB, Eurostat, Danske Bank Markets Survey-based inflation expectations are anchored but could follow market expectations lower In contrast to market-based inflation expectations, survey-based inflation expectations have not declined but the longer-term inflation expectations actually increased a bit in the latest survey published mid-july. The question is whether the lower oil price, stronger effective EUR and weakness in China will also result in less anchored survey-based inflation expectations. The next survey is due for release on 23 October. 5 27 August 2015 www.danskeresearch.com
Survey-based inflation expectations are anchored but could start to decline later Source: ECB, Danske Bank Markets Domestic demand is still looking okay negative impact on sentiment will be monitored closely The euro area recovery continues and the PMIs, which the ECB considers in its economic assessment, improved in August and suggest activity will strengthen in Q3 after disappointing a bit in Q2. The ECB will closely monitor any negative impact from the weakness in China. In our view, the biggest risk stems from a weakness in sentiment, whereas the direct impact on export is not a game changer but a headwind. Domestic demand looks okay negative impact on sentiment will be monitored Source: Eurostat, Markit PMI, Danske Bank Markets Full impact of previous easing has not been seen yet money supply signals stronger recovery Although it was not the ECB s intention to cause an upward movement in inflation by expanding its monetary base, the signal from growth in real M1 money supply is that GDP growth will strengthen in H2, thereby supporting inflation. We believe the ECB will await some evidence on whether the historical correlation holds before it eases monetary policy further. 6 27 August 2015 www.danskeresearch.com
Full impact of previous easing has not been seen yet Source: ECB, Eurostat, Danske Bank Markets Cheaper and more accessible bank lending continues to support the recovery Following the introduction of the negative deposit rate borrowing costs have declined to historically low levels with the lower costs being widely distributed across the euro area countries. Added to this, lending to both households and non-financial corporations is recovering, which supports activity. As long as this transmission of the monetary policy easing remains in place, we expect the ECB to remain somewhat patient. Cheaper and more accessible bank lending continues to support the recovery Source: ECB, Danske Bank Markets 7 27 August 2015 www.danskeresearch.com
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