Investment Research General Market Conditions ECB preview: another minor hawkish twist Pernille Bomholdt Henneberg Jens Peter Sørensen Christin Tuxen Chief Analyst Chief Analyst Chief Analyst +45 45 13 20 21/+44 20 7410 8157 +45 45 12 85 17 +45 45 13 78 67 perni@danskebank.com jenssr@danskebank.dk tux@danskebank.dk 14 July 2017 Investment Research www.danskebank.com/ci Important disclosures and certifications are contained from page 17 of this report
ECB preview: another minor hawkish twist In line with other global central banks, ECB communication has turned hawkish recently with Mario Draghi arguing that in a situation where the economy continues to recover, a monetary policy tightening could be needed in order to keep the policy stance broadly unchanged. In our view, these comments were intended to prepare the market for a reduction in QE purchases from next year, which is likely to be announced at the meeting in September. We still expect the ECB to continue its QE purchases but at a reduced pace of EUR40bn per month in H1 18, keeping the end-date dependent on the inflation outlook. That said, we believe it is most likely the ECB will taper towards zero in H2 18. Added to this, the minutes from the June meeting revealed that the ECB discussed whether to revisit the QE easing bias where it signals its readiness to increase the size and/or duration of QE. We expect the ECB to discuss this easing bias at the upcoming meeting but believe it will deliver only a minor twist and remove its readiness to increase the size of QE while maintaining the flexibility in terms of duration. Together with this, the ECB could add that the duration part of QE will be reconsidered at the meeting in September, when the ECB has updated inflation projections. Despite the hawkish comments mentioned above, the ECB has also expressed concern about an unwarranted tightening of financial conditions. Related to this, Draghi s communication has been that the ECB needs to be persistent in monetary policy in order to be assured about the return of inflation to the objective while any adjustments to the monetary policy stance have to be made gradually. Finally, we expect the ECB to have discussed tapering at the upcoming meeting after Draghi rejected such discussions at the latest meeting in June. In our view, such a discussion will be in line with the latest communication that monetary tightening could be needed in order to keep the policy stance broadly unchanged. In fixed income markets, tapering is primarily an issue for Italy as well as the outright level for yields. However, there is plenty of cash in the system and the ECB will have a large reinvestment need in coming years. Hence, any significant widening of the BTPS-Bund spread is not expected to be persistent given the strong domestic investor base in BTPS. The July ECB meeting will, if anything, likely add to upside risks for EUR/USD. When Draghi started the exit talk at the Sintra conference he in our view opened the lid for the cross, i.e. this was the catalyst for starting to correct its long-standing undervaluation. We still see EUR/USD in a range around 1.13 near term but risks remain on the upside longer term. 2
ECB preview: Another minor hawkish twist 1. ECB s (and other CBs) hawkish twist despite lack of inflation 2. ECB exit scenarios suggest the hiking cycle is priced too aggressively 3. Strong economic data is the ECB falling behind the curve? 4. Tapering an issue for Italy but domestic investor base is supportive 5. Upside risks to EUR/USD mounting but position a roadblock 3
#1: ECB s (and other CBs) hawkish twist despite lack of inflation Draghi s hawkish twist indicates ECB is ready for some tightening Hawkish twist but focus on need for gradual adjustments: In line with the Fed, the Bank of Canada and the Bank of England, the ECB has expressed a hawkish stance recently disregarding falling (core) inflation and inflation expectations, saying they are all temporary. The global thinking seems to be that the Phillips curve is working, implying that the current stronger economic activity will translate into higher underlying price pressure eventually. Along the same lines, Draghi argued for the first time recently that the threat of deflation is gone and reflationary forces are at play. From an ECB watcher perspective, the most notable comment was Draghi indicating that the ECB was ready to tighten its monetary policy stance as he said, the central bank can accompany the recovery by adjusting the parameters of its policy instruments not in order to tighten the policy stance, but to keep it broadly unchanged. Despite this hawkish twist, the ECB argues any adjustments to the monetary policy stance have to be made gradually. Added to this, it continues to argue it needs to be persistent in the monetary policy in order to be assured about the return of inflation to the objective. Finally, the ECB has expressed some concerns about an unwarranted tightening of financial conditions (see table and more on slide 6). Tighter financial conditions following Draghi s hawkish twist 31-May-17 30-Jun-17 13-Jul-17 ECB policy rates and balance sheet: Refi rate 0.00% 0.00% 0.00% Deposit rate -0.40% -0.40% -0.40% Balance sheet, bn 4,196 4,210 Inflations indicators: Euro area HICP, y/y 1.40% 1.30% Euro are core inflation, y/y 0.90% 1.10% 5y5y inflation expectations 1.56% 1.59% 1.59% Oil, EUR 50.3 47.9 48.4 Activity indicators: Euro area PMI manufacturing 57.0 57.4 Euro area PMI services 56.3 55.4 Euro area PMI composite, new orders 55.9 56.0 EUR surprise index 40.6 30.3 37.2 Unemployment rate 9.3% Lending indicators: M3, y/y 5.00% Loans to NFC, y/y 2.40% Cost of borrowing NFC, y/y 1.76% Market based indicators: EUR/USD 1.12 1.14 1.14 Effective euro (EER-38), 1m change 1.60% 2.86% 1.23% 2y German gov yield -0.71% -0.57% -0.61% 10y German gov yield 0.30% 0.47% 0.60% 5y EUR real swap rate -1.04% -0.96% -0.96% Eurostoxx 50, past 2 weeks price change -0.84% -2.88% 1.63% Source: Bloomberg, Macrobond Financial, Danske Bank 4
#1: ECB s (and other CBs) hawkish twist despite lack of inflation We expect a small change to the ECB s QE easing bias Another minor twist to the ECB s forward guidance: The minutes from the ECB meeting in June where the ECB removed the or lower from the forward guidance on policy rates revealed that it also discussed whether to revisit the QE easing bias, signalling the ECB s readiness to increase QE in terms of size and/or duration (see point 5 in the box). In June, the ECB decided to maintain its guidance as the assessment of the prospects for a sustained adjustment argued for patience, as the inflation outlook remained vulnerable to a premature tightening of the monetary policy stance. While we do not believe the ECB will conclude the inflation outlook has changed, the latest shift in focus from lack of inflation to the stronger recovery is likely to be accompanied by a minor twist in the QE easing bias by removing the readiness to increase the size of QE. In our view, there is a risk that some ECB members will see the latest tightening of financial conditions as a headwind to inflation, which should keep the ECB sidelined ahead of its inflation update in September (see more on slide 6). On the other hand, the global shift in central bank thinking opens the door for the ECB delivering a more hawkish message via its QE easing bias. The ECB s forward guidance in five parts: Key ECB interest rates are expected to remain at present or lower levels Source: ECB, Eurostat, Danske Bank Markets (1) Level of policy rates (2) Policy rates horizon for an extended period of time, and well past the horizon of our net asset purchases. (3) QE magnitude Net asset purchases, at the current monthly pace of EUR60bn, are intended to run until the end of December 2017, or beyond, if necessary (4) QE tapering condition and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. (5) QE flexibility If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase programme in terms of size and/or duration. 5
#1: ECB s (and other CBs) hawkish twist despite lack of inflation Financial conditions have tightened over the past few months ECB is concerned about tighter financial conditions: The minutes from the ECB meeting in June revealed that the ECB is concerned about tighter financial conditions and that changes in communication could be perceived as more fundamental changes in policy direction. According to the minutes, this could trigger unwarranted movements in financial conditions, which could put the prospects of a sustained adjustment of inflation at risk. The euro is stronger than in the latest ECB projection Since the latest forecast update from the ECB, financial conditions have tightened across a number of parameters: EUR/USD has gone from 1.09 to 1.14 10Y German bond yields have risen from 40bp to 57bp The first deposit rate hike is again priced in for September 2018 after being expected in at end-2018 prior to the latest ECB meeting 5Y5Y inflation expectations had been down at 1.50% but have recovered back to 1.60% The oil price is around USD2.0/bbl lower at USD48.2/bbl. Added to the above, the effective EUR is around 1.5% stronger than what was assumed in the ECB s projection in June. This should result in an aggregate 0.15pp lower inflation rate after three years, according to OECD estimates. Notably, the stronger euro will be a drag on core inflation, which the ECB currently expects to go above its historical average in 2019. Source: ECB, European Commission, Eurostat, Danske Bank Markets 6
#1: ECB s (and other CBs) hawkish twist despite lack of inflation Tightening speculation driving markets but no periphery widening Higher German yields but periphery spreads are tighter Real yields have risen as inflation expectations stay low The latest tightening speculations have lifted German yields but spreads have not widened which has previously been a market concern. This should be welcomed at the ECB as e.g. France and Italy still struggle with low inflation. Source: ECB, Danske Bank Markets Source: Bloomberg, Danske Bank Markets The upward trend in nominal yields starting in Q4 16 has been driven mainly by higher real rates as inflation expectation have risen more modestly and even declined for most of this year so far. This financial tightening could spark some concerns among ECB members. 7
#2: ECB exit scenarios suggest the hiking cycle is priced too aggressively The market is pricing in the deposit rate at 0.0% for end-2019 The first ECB deposit rate hike is priced in for mid-2018: The hawkish communication from the ECB has also moved forward the expectations of policy rate hikes and the first 10bp deposit rate hike from the ECB is currently priced in for September 2018. We consider this to be aggressive pricing especially as the ECB still argues that (1) policy rates are expected to stay at present levels well past the QE purchases and (2) it intends to continue its QE purchases until December 2017 and longer if necessary. Related to the first point, we expect the ECB to stick to this sequencing in the exit strategy, meaning it will not hike policy rates as long as QE is running as this was clearly communicated from the ECB after speculation about the sequencing strategy intensified earlier this year. In our base case, the ECB will continue its QE purchases at EUR40bn per month in H1 18, but in a very aggressive tapering scenario where QE is assumed to be terminated in March 2018 (see slide 9), the market pricing implies the ECB should hike seven months after having ended QE. The following two 10bp rate hikes are priced in intervals of four meetings, meaning the ECB should hike again in February 2019 and August 2019 followed by a hike in December 2019, bringing the deposit rate out of negative territory at the end of 2019. Deposit rate should be out of negative territory by end-2019: Source: ECB, Eurostat, Danske Bank Markets 45 40 35 30 25 20 15 10 5 0-5 bp -0.9-0.6-0.4 Jul-17 ECB ECB dated Eonia swaps (assuming neutral Eonia is 5bp above deposit rate) 8.7 6.5 4.4 2.7 1.0 1.1 Dec-17 ECB May-18 ECB 11.2 Sep-18 ECB 13.9 18.8 16.5 Jan-19 ECB 21.5 24.2 26.8 May-19 ECB 29.5 32.2 35.0 Sep-19 ECB 38.1 41.5 8
#2: ECB exit scenarios suggest the hiking cycle is priced too aggressively Various tapering scenarios show QE continuing until mid-2018 QE tapering options: Moderate: reduce purchases by EUR10bn per month => QE ended June 2018 per meeting => QE ended September 2018 if (quarterly) updated inflation projection points to a sustained adjustment => QE ended April 2019 (earliest) Slow: reduce purchases by EUR5bn per month => QE ended December 2018 per meeting => QE ended June 2019 if (quarterly) updated inflation projection points to a sustained adjustment => QE ended September 2020 (earliest) Fast: reduce purchases by EUR20bn per month => QE ended March 2018 per meeting => QE ended May 2018 if (quarterly) updated inflation projection points to a sustained adjustment => QE ended July 2018 (earliest) In the scenarios above, we assume the ECB continues to reinvest the principal payments received under QE, which is the current communication from the ECB. However, it could include the reinvestments in the fixed monthly purchases whereby it would reduce the new monthly purchases further. In base case, QE is reduced but not tapered towards zero Source: ECB, European Commission, Eurostat, Danske Bank Markets 90 80 70 60 50 40 30 20 10 EUR bn 0 Mar 15 Sep 15 Mar 16 Sep 16 Mar 17 Sep 17 Mar 18 Sep 18 QE most likely taper towards zero in H2 18 Current 'intended' QE purchases Monthly QE purchases We expect the ECB to announce an extension of its QE purchases but at a reduced pace of EUR40bn per month for six months and keeping the end-date dependent on the inflation outlook. That said, we believe it is most likely the ECB will taper towards zero in H2 18. Expected QE extension in Sep-17 Past QE purchases 9
#2: ECB exit scenarios suggest the hiking cycle is priced too aggressively The market believes in ECB hikes but not in higher inflation The market is not pricing in higher inflation in coming years Inflation expectations below QE announcement levels 2.00% While the market is pricing several rate hikes from the ECB over the coming years, it is not pricing 1.50% higher inflation. Currently, inflation is priced at 1.1% in 2018 and 1.2% in 2019 which is considerably below the ECB s forecast of 1.3% and 1.6%, respectively. 1.00% 0.50% 0.00% -0.50% -1.00% Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19 HICP inflation Market pricing ECB inflation forecast (Jun-17) Source: ECB, Eurostat, Danske Bank Markets Source: ECB, Eurostat, Danske Bank Markets The medium-term inflation expectations (5Y5Y inflation swap) are also low at 1.6%, which is below the level when the ECB announced QE. Nevertheless, Draghi has argued recently that inflation expectations are secure, implying that short-term factors should not ultimately affect the inflation trend. 10
#3: Strong economic data is the ECB falling behind the curve? Focus on economic recovery not lack of inflation pressure Strong PMI figures but labour market slack still a headwind: As mentioned above, the ECB seems to have joined the global thinking that the Phillips curve is working, implying the current stronger economic activity will eventually translate into higher underlying price pressure. Related to this, Draghi has recently said that to understand inflation dynamics requires dividing the inflation process into (1) the effect of monetary policy on aggregate demand and (2) the effect of aggregate demand on inflation. PMI figures suggest central banks should hike policy rates Regarding the first factor, the PMI figures suggest the ECB is starting to fall behind the curve in its monetary policy tightening cycle. However, when it comes to the second factor, the large amount of slack in the labour market which the ECB was very focused on ahead of the latest ECB meeting is likely to prevent a sustainable pickup in wage inflation, which should also be kept down due to the past years low inflation prints. The experiences of countries further ahead in the recovery are that it takes time before wage pressure increases. Added to this, low inflation expectations could be an issue as seen in Sweden where the latest industry wage deal showed that true inflation expectations are lower than stated, in our view. Source: Macrobond Financial Danske Bank 11
#3: Strong economic data is the ECB falling behind the curve? Wage pressure is low in countries with tight labour markets Labour market slack remains an issue in the euro area Lower wage pressure in countries with tight labour markets Source: ECB, Eurostat, Danske Bank Markets Source: Macrobond, Danske Bank 12
#3: Strong economic data is the ECB falling behind the curve? The ECB believes the Phillips curve is working and is very steep Wage growth and core inflation should eventually go higher ECB expects a much steeper Phillips curve ECB 2019 Wages: 2.4% Unemp: 8.4% ECB 2018 Wages: 2.1% Unemp: 8.8% ECB 2017 Wages: 1.7% Unemp: 9.4% ECB 2016 Wages: 1.3% Unemp: 10.0% Source: ECB, European Commission, Eurostat, Danske Bank Markets Source: ECB, European Commission, Eurostat, Danske Bank Markets 13
#4: Tapering an issue for Italy but domestic investor base is supportive FI-tapering how much is priced in? If we look at our three basic parameters for how much is priced in of the tapering discussion then: The Bund ASW-spread is almost fully pricing in the tapering after the recent decline and the normalisation of the repo-rates for Bunds. So, limited potential for a further tightening of the Bund ASW-spread. Looking at the slope of the curve, the 10-30Y EUR swap curve is very steep relative to the level, for e.g. 2Y yields (as shown in the chart). Hence, we see limited potential for a further steepening of 10-30Y. The outright level for 10Y yields is also higher, especially as the ECB will still be a significant buyer of bonds in coming years due to the significant reinvestment need as well as keeping rates low. 10-30Y slope much too steep relative to outright 2Y yields bp 30Y-10Y EUR swap (l.a) 2Y German govt (r.a.) 75-0.50-0.55 70-0.60 65-0.65 60-0.70-0.75 55-0.80 50-0.85-0.90 45-0.95 40-1.00 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 Source: Bloomberg, Danske Bank Markets Jens Peter Sørensen, Chief Analyst, jenssr@danskebank.dk, +45 45 12 85 17 14
#4: Tapering an issue for Italy but domestic investor base is supportive Tapering is mainly an issue for Italy, but strong domestic investor base is supportive The knee-jerk reaction to the discussion of tapering is likely to be higher yields and steeper curves as well as wider spreads between the core and periphery. If we look at spreads between periphery and core, then Spain seem almost immune to tapering discussions as shown by the 10Y SPGB-Bund spread, as we are now back to levels before Frexit and the initial discussion of tapering back in the autumn 2016. The 10Y spread between Italy and Germany has been under pressure from higher rates since summer 2016 220 200 180 160 140 120 bp Italy vs. Germany Spain vs. Germany 10Y swap rate (r.a.) 1.20 1.00 0.80 0.60 0.40 0.20 Furthermore, the 10Y France versus the Bund is back to the old trading range before Frexit. However, Italy is still struggling, but there is a very strong domestic investor base that could boost BTPS if the spread widens too much. 100 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 The 10Y spread between Italy and Germany has been under pressure from higher rates summer 2016 bp 220 210 200 190 180 Italy vs. Germany France vs. Germany (r.a.) 0.00 100 90 80 70 170 160 150 140 130 120 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 60 50 40 30 20 Source (both charts): Bloomberg, Danske Bank Markets Jens Peter Sørensen, Chief Analyst, jenssr@danskebank.dk, +45 45 12 85 17 15
#5: Upside risks to EUR/USD mounting but position a roadblock FX: a Sintra accord? Upside risks to EUR/USD mounting - but positioning a roadblock near term The July ECB meeting will, if anything, likely add to upside risks for EUR/USD: when Draghi started the exit talk at the Sintra conference, he also opened the lid for the cross for good, i.e. this was the catalyst for the FX market to start to correct its long-standing undervaluation. We still see EUR/USD in a range around 1.13 near term but risks remain on the upside longer term. That said, speculators are now long EUR/USD (IMM data), which suggests that further upside near term will be more difficult to bring about. If the ECB removes its readiness to increase the size of QE (as is our base case for July), then the FX market should merely see this as a natural follow-up to Draghi s speech at the Sintra conference in late June. That is, it would simply segment the idea that the ECB has started its journey if very slowly towards an exit on negative rates, a move already partly priced into EUR/USD. The story of EUR/USD in H1: higher highs, higher lows as risks evaporate in the euro area More broadly for the FX market, the seemingly synchronised urge for policy normalisation among central banks and led by the ECB - recently may be dubbed the Sintra accord. Central banks including the ECB - now appear reasonably complacent regarding the inflation outlook to possibly leave worries over the deflationary impact of currency appreciation behind. In that sense, the Sintra talk may be viewed as an acceptance of broader USD weakness ahead (and thus gives some association with the 1985 Plaza accord if clearly not as vocal). Christin Tuxen, Chief Analyst, tux@danskebank.dk, +45 45 13 78 67 Source: Bloomberg, Danske Bank Markets 16
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