Investment Research General Market Conditions 14 January 2015 Euro area outlook for 2015 Deflation but the good kind The euro area slipped into deflation in December 2014 and we expect the inflation rate to remain negative during most of 2015. The current outlook for deflation is not dangerous, as it is mainly driven by the oil price drop, which only has a temporary impact on energy price inflation. Inflation is set to turn positive again in 2016 even if the oil price remains at the current very low level. Nevertheless, around a year of deflation gives a significant risk of second-round effects, where wages and inflation expectations follow inflation lower. The ECB cannot do much about lower oil prices, but it can reduce second-round effects by a credible monetary policy, which stabilises inflation expectations. We expect the ECB to announce QE at the meeting on 22 January and focus should be on providing enough stimulus to support inflation expectations. Further easing would also support inflation through a continued euro depreciation. Fixed income and inflation swap markets are sensitive to changes in energy prices, and the oil price drop is pushing down the pricing of future inflation. From a trading perspective, a necessary condition for positioning for a rebound in B/E inflation is that oil prices stop sliding, but we are still not there yet. Research papers: Recovery despite deflation 12 January Short-term weakness fades 13 January Deflation but the good kind 14 January ECB will buy government bonds 15 January Impact of broad-based QE 16 January Deflation during most of 2015 but mainly due to falling commodity prices Senior Analyst Pernille Bomholdt Nielsen +45 45 13 20 21 perni@danskebank.dk Senior Analyst Lars Tranberg Rasmussen +45 45 12 85 34 laras@danskebank.dk Important disclosures and certifications are contained from page 8 of this report. www.danskeresearch.com
Deflation during most of 2015 mainly due to the oil price decline The euro area slipped into deflation in December on the back of the significant decline in the oil price. Looking ahead, we expect headline inflation to decline further and already in January it is likely to fall to -0.4% y/y. This should follow as the oil price has continued its free fall at the beginning of 2015, while it also reflects that the full impact from the latest sharp decline in the oil price has not been seen yet. Based on the low oil price, we expect headline inflation to remain negative until Q4 and be -0.1% on average in 2015. This is clearly below the Bloomberg consensus that inflation will be +0.6%. Nevertheless, we see downside risk to our inflation forecast, as long as the oil price continues to reach new lows. Euro deflation during most of 2015...... mainly due to the decline in the oil price Source: Bloomberg, Eurostat, Danske Bank Markets The negative inflation is mainly due to the oil price decline, but it also reflects that core and food price inflation are low in a historical perspective. During summer 2014 food price inflation was negative for the first time since the financial crisis, while core inflation has balanced around its new historical low of 0.7% since September. Although core inflation is low, the current deflation is not a dangerous kind. First, as we have argued in Recovery despite deflation, the lower energy price inflation boosts private consumption through higher real wage growth. Added to this low core inflation primarily reflects low inflation in non-energy industrial goods, which has been negatively affected by the euro strengthening. On the other hand, service price inflation, which is highly dependent on labour as an input and closely related to wage growth, has remained relatively stable. Lower commodity prices gives higher real wage growth Low core inflation due to non-energy industrial goods inflation Source: ECB, Eurostat, Danske Bank Markets 2 14 January 2015 www.danskeresearch.com
Having said that, the outlook for deflation for almost a year increases the risk of unanchored inflation expectations. This also follows as the low rate of inflation is broadbased. Currently, 50% of the inflation components in HICP are below 1%, which is worse than what was observed during the financial crisis. The worsening reflects that the share of inflation components in deflation has increased from around 10% in 2012 to above 30% at end-2014, while the share of components with inflation between 0% and 1% has increased from 10% to around 20%. The very low price pressure is broad-based 50% of the inflation components are below 1% 5Y5Y inflation exp effective exchange headline inflation rate higher price preassure oil price [EUR] core inflation energy price inflation wage growth taxes global food prices [EUR] short term unemp food price inflation Newest data Q4 2007 Source: Bloomberg, Eurostat, Danske Bank Markets Higher inflation in 2016 even if the oil price does not recover Looking ahead, we expect the oil price to eventually increase from the very low level and the experience of the 1986 oil glut indicates that the oil price will recover to USD85/bl in the medium term. We are still not there yet, but when the oil price stabilises it will increase the contribution to headline inflation from energy prices but with a lag. Based on this we expect headline inflation will turn positive again in October. Even if the oil price does not increase but remains at the current level, headline inflation should turn positive again in the beginning of 2016. This follows as the low energy price inflation only reflects first-round effects of the oil price decline, which has no lasting deflationary effects, but only gives a lower price level. There is also evidence of indirect effects of the oil price decline in some energy intensive producer prices as well as in consumer service prices related to transport. But in line with the effect on energy price inflation the effects are only temporary although there is a longer lag before these effects are seen. Energy price inflation set to go higher with unchanged oil price HICP inflation turns positive in 2016 with unchanged oil price Source: Bloomberg, Eurostat, Danske Bank Markets Source: Bloomberg, Eurostat, Danske Bank Markets 3 14 January 2015 www.danskeresearch.com
Risk of second round-effects The risk is that the oil price decline results in lasting and much more dangerous deflationary effects. This will be the case if the oil price decline results in second-round effects where wages and inflation expectations follow inflation lower. Lower wage growth would follow due to wage indexation but could also be seen under wage negotiation processes as the low inflation makes it easier for employers to argue for low nominal wage growth. The risk of deflationary effects increases further if inflation expectations are unanchored by changes in energy prices. The second-round effects are generally hard to measure, as wage setting is also affected by the business cycle situation, competitive pressure across markets and the wage-setting institutions. But in our view there have been signs of second-round effects as wage growth is down at 1.3% y/y, which is the lowest rate in more than 10 years. The latest decline in wage growth is not a result of a worsening in the labour market as the unemployment rate has declined and employment growth has turned positive. The short-term unemployment rate, which is a good leading indicator for wage growth, is also lower. However, the lack of spill-over to wages is also due to the large amount of slack in the labour market and cannot only be seen as second round effects. Sign of second round effects in wage growth Weak price pressure also due to slack in the labour market Source: ECB, Eurostat, Danske Bank Markets Another sign of second round effects is the decline in inflation expectations. As mentioned above, this reinforces the downward pressure on wages, and the risk is that inflation is shifting to a lower equilibrium level below 2% as wage earners become satisfied with lower wage increases when prices are expected to increase at a slow pace. Market based inflation expectations far from the target Professional forecasters inflation expectations are also lower Source: Bloomberg, ECB, Danske Bank Markets Source: ECB, Danske Bank Markets 4 14 January 2015 www.danskeresearch.com
The ECB cannot do much about falling oil prices and the low energy price inflation, but it can reduce second-round effects by a credible monetary policy strategy, which stabilises inflation expectations. In light of this we expect the ECB to announce government bond purchases at the meeting on 22 January. Focus for the ECB should be on providing enough stimulus to a) convince wage earners that they should expect 2% inflation and b) generate enough demand to get unemployment down and dampen the downside pressure on wage increases. Weaker euro puts upwards pressure on inflation Further monetary easing from the ECB should at the same time support inflation through a weakening of the effective euro. This follows as the currency depreciation boosts import prices, which in turn puts upward pressure on domestic prices. Based on our expectation that the ECB will announce QE in January the effective euro should weaken further during H1 and the aggregate weakening of around 10% should support inflation by around 0.3pp in 2015 and 0.7pp in 2016. The main impact of the euro weakening should be seen in non-energy industrial goods inflation. However, it printed negative in Q4 14 and we are still waiting for the first evidence that the impact of the past euro strengthening is waning. The risk is that the impact on inflation will be smaller than usually as companies are absorbing the impact of the currency depreciation due to weak demand and/or low inflation expectations. Looking ahead, we expect private consumption to continue to increase, implying companies will be more confident that lack of demand is not a concern. Based on this we expect the pass-through to consumer prices of the cost of the currency depreciation to be seen in H1. Added to this further easing from the ECB will strengthen the spill-over if the monetary easing results in higher inflation expectations. Euro depreciation puts upward pressure on inflation 10% euro weakening should increase inflation by 0.3pp in 15 Source: Bloomberg, Danske Bank Markets Source: OECD, Danske Bank Markets The conclusions above imply we expect core inflation to slowly increase during our forecast horizon. This should also follow as the stronger recovery will continue to give a lower unemployment rate which supports wage pressure. However, the large amount of slack in the labour market should imply that the impact on wage growth will be modest. In light of this we expect a decline in core inflation to 0.5% y/y in March. 5 14 January 2015 www.danskeresearch.com
1yr fwd inflation Euro area outlook for 2015 Second-round effects also reflected in structural changes The second round effects are also seen by a downward shift in the Philips curve (relationship between rates of unemployment and corresponding rates of inflation) as this reflects a lower rate of inflation for the same rate of unemployment. We have included the labour dependent service price inflation in our Philips curve, hence the downward shift reflects lower wage growth, which is likely to be due to a decline in inflation expectations. This structural change in the labour market is also reflected by a change in the relationship between the unemployment rate and the job vacancies (the Beveridge curve). The Beveridge curve shifted upwards at the beginning of 2010, as there was an increase in job vacancies which was not caused by an increase in the unemployment rate. Source: Eurostat,EU Commission, Danske Bank Markets *Job vacancy is measures as limited production due to labour Steep inflation curve Global fixed income and inflation swap markets are sensitive to changes in energy prices, and currently the drop in oil prices in particular is pushing down the market pricing of future inflation (break/even inflation). In some sense, this is counterintuitive since, at least for the euro zone, we should expect that lower energy prices should eventually lead to higher private demand and hence higher future inflation. This view is to some extent reflected in the B/E curve, which is steep as seen in the chart below, where we have derived 1Y forward gaps from the current spot B/E curve. The forward rates are consistent with the market pricing in a return to positive inflation already in 2016 and then a gradual increase towards 1% when adjusted for estimated term premiums. Steep inflation curve Inflation priced to move above 1% 2.50 % % 2.00 1.50 1.00 0.50 0.00-0.50 B/E 1yr gaps -1.00 Oct-15 Oct-17 Oct-19 Oct-21 Oct-23 Source: Danske Bank Markets 2.00 B/E adjusted for term premium 1.50 Estimated term premium 1.00 0.50 0.00 1 2 3 4 5 6 7 8 9 10-0.50-1.00 Years Source: Danske Bank Markets To get a sense of the dynamics of the B/E curve we have made a simple principal component analysis (PCA). Interestingly, the PCA shows that one factor alone drives more than 80% of the total monthly variation of the curve. And judging from the loading of the first principal component is it pretty clear that the B/E curve to a very large extent is driven by the front of the curve. 6 14 January 2015 www.danskeresearch.com
A simple principal component analysis shows that one factor drives 84% of the total monthly variation in the curve Loading on principal component shows that the curve is driven from the front 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% PC1 PC2 PC3 PC4-14 0.50 0.40 0.30 0.20 0.10 0.00 Loading on PC1 Source: Danske Bank Markets Source: Danske Bank Markets From a trading perspective this implies that a necessary condition for positioning for a rebound in B/E inflation is that oil prices stop sliding and hence short-term inflation expectations stabilise. We are still not there yet. However, as most of the oil price decline is now behind us, we believe a more prudent strategy for the current environment would be to position for a flatter B/E curve, as investors could benefit from attractive roll-down and get some protection against the expectations of a rebound in inflation. 7 14 January 2015 www.danskeresearch.com
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