Euro area and ECB outlook: Hot topics in 2016 Pernille Bomholdt Henneberg Senior Analyst perni@danskebank.com +45 30 51 53 75 10 December 2015 Investment Research Important disclosures and certifications are contained from page 41 of this document
Euro area and ECB outlook: Hot topics in 2016 The disappointing ECB meeting last week has resulted in speculation about whether the ECB will be forced to ease again in 2016. From a market perspective, the short-end money market curve remains inverted and some probability of another deposit cut already in March is priced in. Market based inflation expectations have also declined following the ECB meeting, signalling more easing is needed in order to bring inflation back towards the ECB s 2%-target. In our view, additional ECB easing is dependent on incoming economic data with the inflation development being crucial. Headline and core inflation will rise sharply in the near term We project a 0.9pp increase in headline inflation over the next two months, while we also expect higher core inflation. The jump in inflation is due to base effects, but should nevertheless ease the pressure on the ECB and keep it off the trigger. Our forecast is around 0.4pp above the current market pricing. The inflation curve is to a very high degree driven from the front-end, hence the jump in inflation should also lift inflation pricing longer out on the curve. PMI figures should continue to indicate solid domestic demand The PMI figures point to improving domestic demand and have been surprisingly resilient to the weakness in EM and the US manufacturing sector. Based on a global industrial recovery, we look for higher manufacturing PMIs, which should support the ECB in keeping the powder dry. The December meeting suggested, that the better growth outlook has lifted the bar for additional and more aggressive easing from the ECB. The unemployment rate is set to approach its structural level quickly We expect the unemployment rate to continue quickly lower as potential growth in the euro area is very weak. On a longer-term horizon, the closing output gap will, in our view, result in a shift in focus away from additional ECB easing, although it is still too early to talk about tightening. When the unemployment rate approaches its high structural level, attention will turn to slack in the labour markets and the time remaining before the wage pressure returns. Given our economic main scenario, we expect the ECB has delivered the end-of-easing. Additional pricing of further rate cuts in March 2016 will, in our view, be too aggressive. We see value in positioning for higher inflation, as our inflation forecast is above what is priced in. Over time, the yield curve should steepen from the long end in a usual end-of-easing move. 2
Euro area and ECB outlook: Hot topics in 2016 Main scenario: Risk factors: ECB end-of-easing De-anchored inflation expectations force ECB to ease Higher inflation Stronger recovery Declining oil price and stronger euro give headwind to inflation ECB is still too optimistic on core inflation Moderate global trade dampens recovery, domestic demand weakens on financial tightening and political risk Lower unemployment The structural unemployment rate is lower than currently estimated and wage growth remains subdued Source: Danske Bank Markets 3
ECB is likely to stay off-the-trigger due to higher inflation Additional pricing of further rate cuts in Q1 will in our view be too aggressive 4
ECB s Q1 16 timeline data should support end-of-easing December January February March 3-Dec: Dec ECB meeting Lower HICP and core inflation projections 21-Jan: Jan ECB meeting 11-Feb: Cut-off date ECB assumptions 3-Mar: Mar ECB meeting (Updated inflation projections) 2-Dec: Nov flash HICP HICP: 0.1% y/y Core: 0.9% y/y 1-3-Dec: Nov final PMI Man: 52.8 Ser: 54.2 1-Dec: Oct unemp. 10.7% 16-Dec: Dec flash PMI DB exp: 53.0 (man) 16-Dec: Dec FOMC meeting 5-Jan: Dec flash HICP HICP: 0.5% y/y Core: 1.0% y/y 8-Jan: Nov unemp. DB exp: 10.7% 22-Jan: Jan flash PMI DB exp: 53.5 (man) 29-Jan: Jan flash HICP HICP: 1.0% y/y Core: 1.2% y/y 27-Jan: Jan FOMC meeting 1-Feb: Dec unemp. DB exp: 10.6% 29-Feb: Feb flash HICP HICP: 0.7% y/y Core: 1.1% y/y 22-Feb: Feb flash PMI DB exp: 54.0 (man) 1-Mar: Jan unemp. DB exp: 10.6% 24-Mar: Mar flash PMI DB exp: 54.2 (man) Source: ECB, Eurostat, Fed, Markit PMI, Danske Bank Markets 5
Markets continue to price in additional ECB easing EUR swap curve re-priced after the ECB s (lack of) action 10 bp but 50% probability of a Q3 deposit cut is still priced in bp 1 5 0 0 0.0-5 -1-10 -2-1.5-15 -20-3 -2.5-25 -4-3.5-30 -35-5 ECB date Eonia swaps assuming 6bp spread to Deposit rate -4.2-4.7-5.0-4.7-40 Jan-15 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Eonia MRO Deposit ECB Eonia fwd Pre Dec ECB -6 Jan-16 ECB Mar-16 ECB Apr-16 ECB Jun-16 ECB Jul-16 ECB ECB depo expectation Sep-16 ECB Oct-16 ECB Dec-16 ECB Source: Bloomberg, ECB, Danske Bank Markets 6
Higher inflation should keep the ECB off-the-trigger ECB is not in easing mode Take-aways from the December ECB meeting The bar for aggressive easing is now higher, as Draghi no longer has a unanimous Governing Council in support for the very dovish stance. Draghi believes the easing announced in December needs time to be fully appreciated. Particularly, he sees the reinvestment of principal payments as important. The ECB considers its policies as being effective in supporting the real economy and is confident the decisions are adequate to achieve its inflation objective. The better growth outlook is important for the ECB s monetary policy stance. The ECB projects inflation to increase toward 1.0% in Q1, but mainly on account of base effects associated with the fall in oil prices in late 2014. ECB expects higher inflation in Q1, but due to base effects Source: ECB, Eurostat, Danske Bank Markets 7
ECB s core inflation projection is still too optimistic ECB is still too optimistic on its core inflation forecast In June, a stronger euro gave a lower core inflation forecast ECB projections 2015 2016 2017 Mar-15 forecast 0.8% 1.3% 1.7% Core inflation Unemployment rate Wage growth Effective euro Jun-15 forecast 0.8% 1.4% 1.7% Sep-15 forecast 0.9% 1.4% 1.6% Dec-15 forecast 0.9% 1.3% 1.6% Mar-15 forecast 11.1% 10.5% 9.9% Jun-15 forecast 11.1% 10.6% 10.0% Sep-15 forecast 11.0% 10.6% 10.1% Dec-15 forecast 11.0% 10.5% 10.1% Mar-15 forecast 1.7% 2.0% 2.3% Jun-15 forecast 1.4% 1.7% 2.3 % Sep-15 forecast 1.6% 1.6% 2.1% Dec-15 forecast 1.4% 1.5% 2.1% Mar-15 forecast -7.9% -0.2% 0.0% Jun-15 forecast -9.5% -0.2% 0.0% Sep-15 forecast -7.8% 0.3% 0.0% Dec-15 forecast -7.1% 0.1% 0.0% Core inflation revised higher Wage growth revised lower Weaker euro Source: ECB, Eurostat, Danske Bank Markets In June, the ECB lifted its core inflation forecast, due to a weaker effective euro. Back then, the labour market development suggested a lower core inflation projection. 8
A stronger euro is a headwind to core inflation going forward The effective euro is stronger than the ECB assumed An unchanged euro will be a headwind to core inflation Source: Bloomberg, ECB, Eurostat, Danske Bank Markets ECB s core inflation forecast is very dependent on the currency development. A stronger euro will be negative for goods price inflation as it has a negative impact on import prices. 9
The labour market is not yet strong enough to lift core inflation The ECB expects a declining unemployment rate but wage pressure will not return before 2017 Source: BLS, ECB, Eurostat, Danske Bank Markets 10
A two-tier deposit system could be needed without a rate cut Excess liquidity will increase significantly in the near term The liquidity will be burned at the negative deposit rate Current situation: EUR576bn is 'burned' at the -30bp deposit rate Forecast, end Mar-17: EUR1275bn will be 'burned' at the -30bp deposit rate EUR699bn EUR409bn EUR409bn EUR113bn EUR167bn Current account Deposit Facility EUR113bn EUR167bn Current account Deposit Facility Remunerated at the MRO rate +5bp (1% min. reserve requirement) Remunerated at the deposit rate -30bp Higher excess liquidity, remunerated at the deposit rate -30bp Source: ECB, Danske Bank Markets Excess liquidity will be boosted by EUR699bn in end March 2017. All of this will be remunerated at the negative deposit rate. 11
A two-tier deposit system could be needed without a rate cut A min-max reserve requirement would reduce the cost A smaller amount of liquidity would pay the deposit rate Forecast, end Mar-17: EUR1275bn will be 'burned' at the -30bp deposit rate TWO-TIER DEPOSIT SYSTEM Forecast, end Mar-17: EUR823bn will be 'burned' at the -30bp deposit rate EUR150bn EUR409bn EUR866bn EUR452bn EUR673bn EUR113bn Current account Deposit Facility EUR113bn Current account Deposit Facility Remunerated at the MRO rate +5bp (1% min. reserve requirement) Remunerated at the deposit rate -30bp Remunerated at 'new' deposit rate (5% max. reserve requirement) Source: ECB, Danske Bank Markets 12
Eonia will still fix low with two-tier deposit system Excess liquidity to remain high - Eonia will still fix very low German banks will benefit from a two-tier deposit system 30% 25% 27% Deposits at national central bank in % of total Eurosystem deposits 20% 20% 15% 16% 10% 5% 0% 7% 8% 5% 4% 3% 3% 2% 0% 0% 1% 2% 2% 1% 0% 0% 0% DE FI NL LU AT FR BE IE ES IT PT GR CY EE LV LT MT SK SI Core 54% Semi-core 33% Periphery 6% Others 7% Source: Bloomberg, ECB, Danske Bank Markets 13
Headline and core inflation will rise due to base effects Inflation markets are too pessimistic on the outlook for inflation 14
Despite the low oil price, inflation will increase sharply Drag from energy prices will fade with unchanged oil price Base effects alone will lift HICP inflation to 0.8% in January Source: Bloomberg, Eurostat, Danske Bank Markets The above scenario is based on the assumptions that food and energy prices are unchanged at current levels. Core inflation is set to follow its historical seasonal pattern (see chart on the next page). 15
Base effects are not only affecting headline inflation Core inflation is also supported by base effects in January Base effects for core are based on the historical seasonality Core inflation will increase to 1.1% if it follows its seasonal pattern. Source: Eurostat, Danske Bank Markets 16
Euro area inflation projection in detail December -15: HICP: 0.5% y/y, core inflation: 1.0% y/y The drop in the oil price in early December is likely to feed immediately into energy price inflation, but despite an estimated monthly decline of 1.0%, the energy price inflation rate should go to -5.1% from -7.3% in November. Food price inflation is also supported by base effects and should have a slightly higher positive contribution to headline inflation despite early signs that non-processed food price inflation has reversed its upward trend. Core inflation should go to up by 0.1pp to 1.0% driven by slightly higher service price inflation. Industrial goods price inflation is forecast to remain unchanged as the lagged impact from the low oil price and euro appreciation in mid-2015 are headwinds. Inflation forecast profile in detail Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 HICP inflation -0.1% y/y +0.2% m/m +0.1% y/y +0.1% m/m +0.1% y/y -0.2% m/m +0.5% y/y +0.2% m/m +1.0% y/y -1.1% m/m Core inflation Services Goods (NEIG) Energy +0.9% y/y +0.5% m/m +1.1% y/y +0.2% m/m +0.9% y/y -0.2% m/m +1.0% y/y +0.4% m/m +1.2% y/y -1.6% m/m +1.2% y/y -1.1% m/m +1.3% y/y -0.1% m/m +1.1% y/y -0.4% m/m +1.2% y/y +0.8% m/m +1.4% y/y -0.4% m/m +0.3% y/y +3.2% m/m +0.6% y/y +0.7% m/m +0.5% y/y 0.0% m/m +0.5% y/y -0.2% m/m +0.8% y/y -3.6% m/m -8.9% y/y -1.7% m/m -8.5% y/y -0.5% m/m -7.3% y/y 0.0% m/m -5.1% y/y -1.0% m/m -1.9% y/y 0.0% m/m Food, alc & tobacco +0.3% y/y -1.7% m/m +1.6% y/y +0.4% m/m +1.5% y/y 0.0% m/m +1.7% y/y +0.3% m/m +1.6% y/y +0.3% m/m January-16: HICP: 1.0% y/y, core inflation: 1.2% y/y The drag from energy price inflation should fade further and assuming oil and gasoline prices are unchanged compared to December, the energy price inflation should go up to -1.9% from -5.1%. Food price inflation should be slightly lower compared to the December forecast due to lower global food prices. Core inflation is supported by base effects and should rise to 1.2%. The lift is based on a 0.3pp rise in industrial goods price inflation and 0.2pp higher service price inflation. Feb-16 Mar-16 Apr-16 May-16 Jun-16 +0.7% y/y +0.4% m/m +0.6% y/y +1.1% m/m +0.6% y/y +0.2% m/m +0.5% y/y +0.1% m/m +0.6% y/y +0.1% m/m +1.1% y/y +0.4% m/m +1.1% y/y +1.4% m/m +1.1% y/y +0.2% m/m +1.0% y/y 0.0% m/m +1.1% y/y +0.1% m/m +1.2% y/y +0.4% m/m +1.5% y/y +0.3% m/m +1.4% y/y 0.0% m/m +1.2% y/y 0.0% m/m +1.3% y/y +0.3% m/m +0.8% y/y +0.4% m/m +0.6% y/y +3.5% m/m +0.6% y/y +0.6% m/m +0.7% y/y 0.0% m/m +0.7% y/y -0.3% m/m -3.2% y/y +0.3% m/m -4.3% y/y +0.5% m/m -4.0% y/y +0.5% m/m -4.4% y/y +0.5% m/m -3.8% y/y +0.5% m/m +1.5% y/y +0.3% m/m +1.6% y/y +0.1% m/m +1.4% y/y +0.1% m/m +1.4% y/y +0.1% m/m +1.5% y/y +0.1% m/m Sourece: Eurostat, Danske Bank Markets 17
Sharp rise in inflation as the drag from the oil price drop fades Higher inflation due to smaller drag from energy prices Core inflation has risen in 15, but should stay subdued in 16 Source: Bloomberg, Eurostat, Danske Bank Markets 18
Variation in inflation is mostly driven by food and energy prices Higher inflation is sensitive to the oil price development Global food prices suggest modest food price inflation Source: Bloomberg, Eurostat, Danske Bank Markets 19
Inflation markets are too pessimistic in the short term Inflation markets price in too low inflation in the near-term 5Y5Y inflation exp. much lower after ECB disappointed 2.00% 1.50% 1.00% Feb-17 1.02% Mar-17 0.90% May-17 0.88% 2017-2019, 1.10% 0.50% 0.00% Jan-16 0.57% Mar-16 0.36% May-16 0.11% Nov-16 0.64% Aug-16 0.46% Aug-17 0.82% -0.50% -1.00% Nov-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19 HICP Market pricing ECB Target Source: Bloomberg, Danske Bank Markets 20
Inflation curve has high correlation to spot inflation Actual inflation is correlated with the entire inflation curve The inflation curve is driven from the front end Source: Bloomberg, Eurostat, Danske Bank Markets 21
Break-even inflation did not contribute to the sell-off in spring Break-even inflation did not support sell-off in spring 15 Post-QE sell-offs: Real yield and break-even contributions 200 bp 180 160 140 120 EUR spring 2015 sell-off soly driven by real yields 100 80 60 40 20 0 FED QE1 17DEC2008 10JUN2009 FED QE2 04NOV2010 08FEB2011 FED OT 22SEP2011 19MAR2012 FED QE3 16NOV2012 11MAR2013 ECB QE 17APR2015 10JUN2015 Real Yield Break-even Source: Bloomberg, Danske Bank Markets 22
Domestic demand is improving and the recovery strengthening Over time, the curve should steepen from the long end, reflecting end-of-easing 23
The recovery is strengthening after soft patch in mid-2015 Survey indicators point to a stronger recovery Money supply has been a good indicator for activity Source: ECB, Eurostat, Markit PMI, Danske Bank Markets 24
#1: Manufacturing sector is supported by bottom in China Chinese PMI signals bottom supports industrial recovery Weakness in euro financial data, but resilient economic data Source: IFO, ISM, Markit PMI, ZEW, Danske Bank Markets 25
#2: Private consumption remains solid due to the low oil price Private consumption should continue to grow but the growth rate is likely to have peaked in line with wages Source: ECB, Eurostat, Danske Bank Markets 26
#3: Exports supported by moderate Chinese recovery Exports supported by moderate recovery in China The euro appreciation pressure will be a headwind to exports Source: Bloomberg, OECD, Danske Bank Markets 27
#4: Cheaper and more accessible bank lending Improved lending after ECB s comprehensive assessment Lower cost of borrowing should support investments Source; ECB, Eurostat, Danske Bank Markets 28
#5: Significant fiscal headwind is becoming a small tailwind Fiscal headwind has faded and will become a tailwind Deficit below 3% criteria, but debt level remains too high 2 %-points of GDP 1 0-1 -2-3 -4-5 2011 2012 2013 2014 2015 2016 2017 Impact on growth Change in cyclically adjusted primary balance Source: European Commission, Eurostat, Danske Bank Markets 29
The unemployment rate is approaching its structural level quickly The closing output gap should eventually result in more hawkish ECB comments 30
The unemployment rate approaches the structural level The euro unemployment rate approaches NAIRU Higher wages and core inflation when NAIRU is reached Source: BLS, Eurostat, European Commission, ONS, Danske Bank Markets 31
Low potential growth gives fast declining unemployment Okun s law : Unemployment rate should not have declined Potential economic growth has weakened significantly Source: ECB, Eurostat, Danske Bank Markets 32
Low potential growth gives fast declining unemployment Low potential growth affects job market trends 1. Lower productivity growth less growth to increase employment 2. Lower labour force growth less employment to reduce unemployment Bottom line: 1. and 2. implies it takes less growth to reduce the unemployment rate Source: Eurostat, Danske Bank Markets 33
Potential GDP growth, % Potential GDP growth, % Low productivity growth implies stronger job market trends The unemployment rate has declined since mid-2013 Different scenarios for the unemployment rate Unemployment matrix Actual GDP growth, % 2016Q4 1.0 1.5 2.0 2,5 0.6 10,6 10,2 9,8 9,4 0.9 10,8 10,4 10,0 9,7 1.2 11,0 10,6 10,3 9,9 1,5 11,2 10,9 10,5 10,1 *Structural unemployment rate 9.9% Unemployment matrix Actual GDP growth, % 1.0 1.5 2.0 2,5 0.6 2019Q4 2017Q3 2016Q4 2016Q3 0.9 n/a 2018Q2 2017Q1 2016Q4 1.2 n/a 2021Q1 2017Q4 2016Q4 1,5 n/a n/a 2018Q4 2017Q2 *Structural unemployment rate 9.9%, **Calculations end in 2020 U t = U t 1 + 0.15 Y t Y t Source: BLS, Eurostat, European Commission, ONS, Danske Bank Markets 34
US and UK wage pressure remained subdued for a long time US wage pressure returns as NAIRU is approached UK wages pick-up as suggested by the labour market Source: European Commission, IMF, OECD, Danske Bank Markets 35
Higher wages when structural unemployment rate is reached Wages will remain low until structural level is reached Positive relation when unemployment is below NAIRU Source: ECB, European Commission, Eurostat, Danske Bank Markets 36
The biggest risk factor is continued low inflation expectations De-anchored inflation expectations could force the ECB to deliver additional easing 37
Risk #1: De-anchored inflation expectations require easing Medium-term inflation expectations far below 2% target 5Y real rates jumped almost 25bp on ECB disappointment Source: Bloomberg, ECB, Danske Bank Markets 38
Risk #2: Stronger euro and low oil price keep inflation low The euro is under fundamental appreciation pressure Core inflation is indirectly affected by the low oil price Source: Bloomberg, Eurostat, Danske Bank Markets 39
Risk #3: Global recovery derails/domestic demand weakens Moderate global trade dampens euro recovery Political uncertainty is a risk to domestic demand 2015 Greek general election 20 Sep Portugal general election 4 Oct Spain general election 20 Dec 2016 Ireland general election Before 8 Apr 2017 French presidential election Apr and May German general election Before 22 Oct 2018 Italy general election In or before 2018 Source: ISM, Markit PMI, Danske Bank Markets 40
Risk #4: Labour market slack keeps wage growth very low Economic slack will keep wage inflation low during 2016 Source: ECB, Eurostat, Danske Bank Markets 41
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