Presentation - Euro area and ECB outlook: Hot topics in 2016€¦ · 10/12/2015 · 10 December...

Investment Research

www.danskebank.com/CI

10 December 2015

Euro area and ECB outlook: Hot topics in 2016

Pernille Bomholdt Henneberg Senior Analyst [email protected] +45 30 51 53 75

Important disclosures and certifications are contained from page 41 of this document

2 www.danskebank.com/CI


• 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.



Source: Danske Bank Markets

Main scenario:

ECB end-of-easing

Higher inflation

Stronger recovery

Lower unemployment

Risk factors:

De-anchored inflation expectations force ECB to ease

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

The structural unemployment rate is lower than currently estimated and

wage growth remains subdued


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


ECB’s Q1 16 timeline – data should support end-of-easing

Source: ECB, Eurostat, Fed, Markit PMI, Danske Bank Markets

3-Mar:

Mar ECB meeting

(Updated inflation

projections)

24-Mar:

Mar flash PMI

DB exp: 54.2

(man)

2-Dec:

Nov flash HICP

HICP: 0.1% y/y

Core: 0.9% y/y

5-Jan:

Dec flash HICP

HICP: 0.5% y/y

Core: 1.0% y/y

29-Jan:

Jan flash HICP

HICP: 1.0% y/y

Core: 1.2% y/y

29-Feb:

Feb flash HICP

HICP: 0.7% y/y

Core: 1.1% y/y

16-Dec:

Dec FOMC

meeting

27-Jan:

Jan FOMC

meeting

11-Feb:

Cut-off date

ECB

assumptions

3-Dec:

Dec ECB meeting

Lower HICP and core

inflation projections

1-3-Dec:

Nov final PMI

Man: 52.8

Ser: 54.2

16-Dec:

Dec flash PMI

DB exp: 53.0

(man)

December March

1-Feb:

Dec unemp.

DB exp: 10.6%

21-Jan:

Jan ECB

meeting

1-Dec:

Oct unemp.

10.7%

8-Jan:

Nov unemp.

DB exp: 10.7%

22-Jan:

Jan flash PMI

DB exp: 53.5

(man)

22-Feb:

Feb flash PMI

DB exp: 54.0

(man)

1-Mar:

Jan unemp.

DB exp: 10.6%

January February


Markets continue to price in additional ECB easing

EUR swap curve re-priced after the ECB’s (lack of) action…

… but 50% probability of a Q3 deposit cut is still priced in

Source: Bloomberg, ECB, Danske Bank Markets

-40

-35

-30

-25

-20

-15

-10

-5

0

5

10

Jan-15 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17

bp

Eonia MRO Deposit ECB Eonia fwd Pre Dec ECB

0.0

-1.5

-2.5

-3.5

-4.2

-4.7-5.0

-4.7

-6

-5

-4

-3

-2

-1

0

1

Jan-16ECB

Mar-16ECB

Apr-16ECB

Jun-16ECB

Jul-16ECB

Sep-16ECB

Oct-16ECB

Dec-16ECB

bp

ECB depo expectation

ECB date Eonia swaps assuming

6bp spread to Deposit rate


Higher inflation should keep the ECB off-the-trigger

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 sup-porting 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 is not in easing mode

ECB expects higher inflation in Q1, but due to base effects

Source: ECB, Eurostat, Danske Bank Markets


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%

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%

Wage growth

Effective euro

Core inflation

Unemployment rate

Core

inflation

revised

higher

Wage

growth

revised

lower

Weaker

euro

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.


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 deve-

lopment. A stronger euro will be negative for goods price inflation as it

has a negative impact on import prices.


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


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

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 .

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

EUR1275bn will be 'burned' at the -30bp deposit rate

Current situation: Forecast, end Mar-17:

EUR576bn is 'burned' at the -30bp deposit rate

EUR699bn

Current account Deposit Facility Current account Deposit Facility

EUR113bn

EUR409bn

EUR167bnEUR113bn

EUR167bn

EUR409bn


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

Source: ECB, Danske Bank Markets

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)

EUR866bn

EUR452bn

EUR150bn

EUR673bn

Current account Deposit Facility Current account Deposit Facility

Forecast, end Mar-17: Forecast, end Mar-17:

TWO-TIER DEPOSIT SYSTEM

EUR409bn

EUR113bn EUR113bn




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


27%

5%

16%

7% 8%

20%

4%

2%3% 3%

0% 0%1%

0%

2%2%

1% 0% 0%0%

5%

10%

15%

20%

25%

30%

DE FI NL LU AT FR BE IE ES IT PT GR CY EE LV LT MT SK SI

Deposits at national central bank in % of total

Eurosystem deposits

Core54%

Semi-core33%

Periphery6%

Others7%


Headline and core inflation will rise due to base effects – Inflation markets are too pessimistic on the outlook for inflation


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).


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

Source: Eurostat, Danske Bank Markets

Core inflation will increase to 1.1% if it follows its seasonal pattern.


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 immedia-tely 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 ha-ve 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 fore-cast to remain unchanged as the lagged impact from the low oil price and euro appreciation in mid-2015 are headwinds.

• January-16: HICP: 1.0% y/y, core inflation: 1.2% y/y

The drag from energy price inflation should fade further and assu-ming oil and gasoline prices are unchanged compared to Decem-ber, 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.

Inflation forecast profile in detail

Sourece: Eurostat, Danske Bank Markets

HICP

inflationCore inflation Services Goods (NEIG) Energy

Food, alc &

tobacco

Sep-15-0.1% y/y

+0.2% m/m+0.9% y/y

+0.5% m/m

+1.2% y/y

-1.1% m/m

+0.3% y/y

+3.2% m/m

-8.9% y/y

-1.7% m/m

+0.3% y/y

-1.7% m/m

Oct-15+0.1% y/y

+0.1% m/m

+1.1% y/y

+0.2% m/m

+1.3% y/y

-0.1% m/m

+0.6% y/y

+0.7% m/m

-8.5% y/y

-0.5% m/m

+1.6% y/y

+0.4% m/m

Nov-15+0.1% y/y

-0.2% m/m+0.9% y/y

-0.2% m/m+1.1% y/y

-0.4% m/m

+0.5% y/y

0.0% m/m-7.3% y/y

0.0% m/m+1.5% y/y

0.0% m/m

Dec-15+0.5% y/y

+0.2% m/m

+1.0% y/y

+0.4% m/m

+1.2% y/y

+0.8% m/m+0.5% y/y

-0.2% m/m-5.1% y/y

-1.0% m/m+1.7% y/y

+0.3% m/m

Jan-16+1.0% y/y

-1.1% m/m

+1.2% y/y

-1.6% m/m

+1.4% y/y

-0.4% m/m

+0.8% y/y

-3.6% m/m-1.9% y/y

0.0% m/m+1.6% y/y

+0.3% m/m

Feb-16+0.7% y/y

+0.4% m/m

+1.1% y/y

+0.4% m/m

+1.2% y/y

+0.4% m/m+0.8% y/y

+0.4% m/m

-3.2% y/y

+0.3% m/m

+1.5% y/y

+0.3% m/m

Mar-16+0.6% y/y

+1.1% m/m

+1.1% y/y

+1.4% m/m

+1.5% y/y

+0.3% m/m

+0.6% y/y

+3.5% m/m

-4.3% y/y

+0.5% m/m

+1.6% y/y

+0.1% m/m

Apr-16+0.6% y/y

+0.2% m/m

+1.1% y/y

+0.2% m/m

+1.4% y/y

0.0% m/m

+0.6% y/y

+0.6% m/m

-4.0% y/y

+0.5% m/m

+1.4% y/y

+0.1% m/m

May-16+0.5% y/y

+0.1% m/m

+1.0% y/y

0.0% m/m

+1.2% y/y

0.0% m/m

+0.7% y/y

0.0% m/m

-4.4% y/y

+0.5% m/m

+1.4% y/y

+0.1% m/m

Jun-16+0.6% y/y

+0.1% m/m

+1.1% y/y

+0.1% m/m

+1.3% y/y

+0.3% m/m

+0.7% y/y

-0.3% m/m

-3.8% y/y

+0.5% m/m

+1.5% y/y

+0.1% m/m


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


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



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

Source: Bloomberg, Danske Bank Markets

Jan-160.57% Mar-16

0.36%

May-160.11%

Aug-160.46%

Nov-160.64%

Feb-171.02%

Mar-170.90%

May-170.88%

Aug-170.82%

2017-2019, 1.10%

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

Nov-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19

HICP Market pricing ECB Target


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



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

Source: Bloomberg, Danske Bank Markets

0

20

40

60

80

100

120

140

160

180

200

FED QE1 17DEC2008 10JUN2009

FED QE2 04NOV2010 08FEB2011

FED OT 22SEP2011

19MAR2012

FED QE3 16NOV2012 11MAR2013

ECB QE 17APR2015 10JUN2015

bp

Real Yield Break-even

EUR spring 2015 sell-off soly driven

by real yields


Domestic demand is improving and the recovery strengthening – Over time, the curve should steepen from the long end, reflecting end-of-easing


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


#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


#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



#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


#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


#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

Source: European Commission, Eurostat, Danske Bank Markets

-5

-4

-3

-2

-1

0

1

2

2011 2012 2013 2014 2015 2016 2017

Impact on growth Change in cyclically adjusted primary balance

%-points of GDP


The unemployment rate is approaching its structural level quickly – The closing output gap should eventually result in more hawkish ECB comments


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


Low potential growth gives fast declining unemployment

Okun’s law : Unemployment rate should not have declined Potential economic growth has weakened significantly



Source: Eurostat, Danske Bank Markets

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: BLS, Eurostat, European Commission, ONS, Danske Bank Markets

Low productivity growth implies stronger job market trends

The unemployment rate has declined since mid-2013

𝑈𝑡 = 𝑈𝑡−1 + 0.15 ∆𝑌 𝑡 − ∆𝑌𝑡

Different scenarios for the unemployment rate

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

Po

ten

tia

l G

DP

gro

wth

, %

Actual GDP growth, %

Unemployment matrix

*Structural unemployment rate 9.9%

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

Unemployment matrix

Actual GDP growth, %

Po

ten

tia

l G

DP

gro

wth

, %


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


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


The biggest risk factor is continued low inflation expectations – De-anchored inflation expectations could force the ECB to deliver additional easing


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



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



Risk #3: Global recovery derails/domestic demand weakens

Moderate global trade dampens euro recovery

Political uncertainty is a risk to domestic demand

Source: ISM, Markit PMI, Danske Bank Markets

2015

2017

2016

Greek general election

20 Sep

Portugal general election

4 Oct

Ireland general election

Before 8 Apr

French presidential election

Apr and May

2018

Italy general election

In or before 2018

German general election

Before 22 Oct

Spain general election

20 Dec



Risk #4: Labour market slack keeps wage growth very low

Economic slack will keep wage inflation low during 2016


Disclosures

This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The author of this research report is Pernille Bomholdt Henneberg, Senior Analyst.

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