Nomura – Waiting for inflation – ECB preview
We are in line with the consensus in expecting all the ECB’s key policy parameters to be left unchanged at this week’s ECB meeting on 27 April. The markets will focus instead on the forward guidance, but we are not expecting any shifts in this either. A surprisingly soft core inflation reading in March combined with some lingering political uncertainties should leave the ECB comfortable for now with the status quo. That being said, if Emmanuel Macron beats Marine Le Pen in the second round of the French Presidential elections on Sunday 7 May that ought to be positive for the regional growth outlook. That has certainly been the markets’ interpretation of recent events over the past day or two. And if, as we expect, the regional growth data continue to improve, we may not have to wait too long before the ECB indicates a change in its policy stance. If, moreover, President Draghi stresses this week that the risks to the regional growth outlook are more evenly balanced instead of being skewed to the downside, which we think is possible, that will provide an important signal to the market about a prospective policy normalisation. But what will it take to trigger that normalisation?
A sustained rise in core inflation would be the ECB’s answer. In our view, the pre-conditions for that sustained climb in inflation are in place. In Figures 1 and 2 and 5-7 we illustrate a range of indicators, including output gaps, capex orders, youth unemployment levels and inflation expectations that all point to a higher level of core inflation in the eurozone in the immediate months ahead. We still wait, however, for that trend to be exhibited in the core inflation data itself.
To be clear, we think core inflation will rise over the next two to three months. That should pave the way for a shift in the ECB’s forward guidance at the next meeting on 8 June. And that in turn should generate an announcement of a tapering of the QE programme at the September meeting for enactment at the start of next year. At this stage, and in line with the ECB’s communication on this matter, we do not believe that policy rates will be lifted until QE purchases have come to an end and specifically not until the latter half of 2018. But the risks to that view are tilted toward a swifter normalisation of interest rates than we are forecasting and a slower normalisation of the QE programme.
Fixed income strategy
Over the past couple of months EUR rates markets have switched between 1) pricing in a faster pace of ECB normalisation (to include a possible shift in the sequencing), and 2) increased political risk (and therefore a slower pace of normalisation). In the first part of this year the focus was firmly on 1) a faster pace of normalisation, as characterised by steeper front-end Eonia slopes, higher yields, wider EGB spreads, tighter swap spreads and steeper long-end curves. The price action on the front end was sharp and fast, as the market began to speculate not only on a faster pace of normalisation but on the possibility of a shift in the sequencing of ECB normalisation, with rate hikes to come first.
In late March several governing council members, including Mr Draghi, pushed back on market pricing by reaffirming the appropriateness of the ECB’s current easing stance. Additionally, the suggestion of there being a shift in the sequencing of normalisation was rejected. This resulted in markets pricing out all hiking expectations for the following 12 months and pricing lower the pace of any tapering. The price action across rates markets was then compounded by a shift onto, 2) heightened political risk, in particular the uncertainty surrounding the first round of the French elections. This compounded shift resulted not only in flatter front-end slopes, but a sharp flight-to-quality bid into Bunds taking the 10yr back to the lows of its recent trading range, wider EGB spreads, wider swap spreads and wider front-end EURUSD cross-currency basis spreads.
With French election risk priced significantly lower, following a strong win in round one by Emmanuel Macron, rates markets are once again likely to start focusing on ECB normalisation – and once the French elections are fully over, we would expect this focus to remain and indeed increase through H2.
However, we expect little signal from the ECB at this meeting. The slight fall we have seen in inflation has afforded the ECB time – and until it sees a sustained rise in inflation, we expect it to continue to re-affirm the appropriateness of its existing easing measures. Indeed, the recent bank lending survey adds further support for the existing easing measures and as yet provides little evidence of the negative policy rates having an adverse impact on the recovery; providing therefore little incentive for the ECB to reignite the normalisation sequencing debate.
For euro rates markets this means we continue to hold onto our front-end Eonia steepeners and EUR swap spread tighteners, with the latter focused on the 2yr, acknowledging small near-term risks. Both are medium-term trades, and while there may be some continued near-term pull-back given the sharp price action following round one of the French elections, the rationale for both trades still holds. We are also biased to EUR 5s30s swap spread steepeners and continue to hold 5s30s BTP steepeners as a high-carry bearish trade on Italy, which has its own election risk at the end of this month. And the trade should further benefit from a reduction, going forward, in ECB buying.
We are currently bullish on EUR. The tail risk from the French election has diminished significantly, while the macro-economic fundamentals of the euro area continue to improve more than other major economy (see “Macr-On vs Le Pen is risk-On”, 23 April 2017). At the meeting this week, we will look for: 1) a possibility of any changes in the ECB’s economic risk assessment, and 2) the ECB’s view on the likely normalisation sequence.
There is a possibility that the ECB and President Draghi might suggest that the risk to the growth outlook is now more balanced. That change would not surprise the market much as the strength of euro area economic data has been clear, but the market and our confidence in near-term ECB normalisation would strengthen.
Our main scenario on the policy normalisation sequence remains that the ECB will not hike its policy rates before ending its QE programme. Recent communication from ECB officials has suggested a high possibility of the Bank keeping its commitment on the sequence unchanged, and we would President Draghi to follow that script this week. Nonetheless, earlier rate hikes could accelerate EUR appreciation further and President Draghi’s stance will be crucial in assessing the speed and magnitude of likely EUR appreciation over the next three to six months (see “EUR: ECB normalization sequence matters”, 30 March 2017).
As we expect no changes in the forward guidance this week, we think the initial EUR reaction to the ECB announcement is likely to be muted again (Figure 4). No change in the forward guidance may be a small disappointment for the market. We also estimate April core CPI released on Friday to be +0.9% y-o-y, slightly weaker than the consensus forecast (+1.0% y-o-y). Although core CPI inflation is still expected to recover from +0.7% y-o-y in March, a weaker inflation recovery may encourage profit-taking from EUR long positions. Core CPI inflation is still likely on track to recover, so the possible dip after the ECB meeting and inflation data later this week may provide a good opportunity to buy EUR
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