In many respects, the ECB’s December policy announcement means that it will be business as usual for the Governing Council in 2017 as it maintains its efforts to push inflation back to target. Predictably, the policy makers left their key interest rates – including the -0.40% deposit rate – unchanged at the levels in place since March. And those rates seem all-but-certain to be left at current levels throughout the coming year too. The amendments to the asset purchase programme were also hardly unexpected, with decisions to extend QE for a further nine months beyond March, alongside technical changes to ensure that it can continue to buy the targeted amount of bonds, meaning that the ECB will maintain a substantial presence in euro area financial markets throughout 2017. The details of the package, however, resulted in a notable shift in asset prices.
In particular, while the timeframe of the ECB’s asset purchase programme was extended at the upper end of expectations, the pace at which those purchases will be conducted will slow to €60bn per month, €20bn per month less than at present. Mario Draghi was at pains to explain that this reduction in the monthly purchase amount did not represent a tapering nor did any Governing Council members call for a tapering in the meeting. And he emphasised the ECB’s willingness to continue to buy bonds beyond the end of 2017 if necessary. Nevertheless, the decision to reduce the monthly purchase rate strongly suggested that policymakers are unconcerned about the marked rise in euro area longer-dated government bond yields seen over recent months. And so, since the meeting, yields on 10Y German bonds have remained close to 0.30%, up more than 40bps from the start of October, while increases in long-term yields on other member states’ government bonds over that period have been larger still.
But while the ECB appears relaxed about the rise in longer-term interest rates, its tweaks to the rules of the QE programme have pushed yields at the short end of the curve to new record lows. From January, the central bank will be able to buy bonds with a remaining maturity of just one year (compared to two years or more at present) and, crucially, at yields below the current floor of -0.40%. With ECB buying of such bonds no longer to be constrained by a lower bound, this week German 2Y yields strikingly fell to -0.80%, about 15bps lower than before the ECB’s announcement and some 45bps lower than at the start of the year. And given the widening differential between euro area and US interest rates, the euro has depreciated below $1.04 to its weakest level against the dollar in fourteen years.
As far as the ECB is concerned this is just what the doctor ordered. The weaker euro will boost growth via net trade while the lower short-term interest rates on new borrowing should support domestic demand. At the same time, as also recognised by the BoJ earlier this year, higher interest rates on longer-dated bonds and the resulting steeper yield curve should support profitability among financial institutions, including banks, pension funds and insurers, and, as such, should bolster wider economic confidence too.
In fact, economic sentiment in the euro area has been improving steadily over recent months, with the latest survey indicators, such as December’s euro area flash PMIs, and the German Ifo and French INSEE business climate indices, pointing to a strengthening of economic growth in the final quarter of the year. We think that euro area GDP growth ticked slightly higher in Q416 to about 0.4%Q/Q, which would be the firmest rate since the first quarter of the year, with French growth matching the aggregate rate and the pace of expansion in Germany higher still. Weather-permitting, the positive momentum should also be maintained into the New Year too. However, like the ECB, we do not expect euro area full-year growth in 2017 to be any firmer than the 1.7% rate we expect for 2016. And despite ongoing monetary stimulus from the ECB, we agree with the central bank that GDP growth is more likely to slow slightly than strengthen in subsequent years too.
Most important for the ECB is the outlook for inflation. Encouragingly, CPI has been inching steadily higher since May. And given higher oil prices in the wake of the OPEC agreement and the accelerated depreciation of the euro we now expect headline inflation to rise to 1.0%Y/Y in December with a near-term peak perhaps a touch above 1½%Y/Y in April. However, core CPI has merely been trending sideways over recent months. And given this persistent lack of underlying price pressures amid significant wage restraint, in the absence of a further sharp move lower in the euro, core inflation might well remain below 1%Y/Y until April and no higher than 1¼%Y/Y over the remainder of 2017 – the kind of price outlook that would merit an eventual extension of ECB QE into 2018 albeit probably at an even slower pace of asset purchase.
That broadly positive economic outlook assumes that there will be no new adverse shocks in 2017. But after a year of major political upsets in the UK and US, investors might be excused for approaching the coming year with some trepidation. However, financial markets have responded calmly to developments in Italy since Matteo Renzi fell on his sword after his ill-judged constitutional referendum. And, so far, the political transition has been orderly too. Indeed, while it might fail to see out the coming year due to a lack of support in the Senate, for the time being Italy’s new government – led by former Minister of Foreign Affairs Paolo Gentiloni with most cabinet ministers retained from the Renzi administration – appears to be conducting itself in a business-like manner, most notably attempting to put in place a workable, and long-overdue, plan for bolstering the country’s banks, albeit likely at a cost to the public purse of up to €20bn.
There are, of course, numerous political events to watch in 2017. In the Dutch election due in March, the far-right Party for Freedom (PVV) of Geert Wilders is currently on track to win the largest representation in parliament. But although it looks likely to win more than one quarter of seats, we expect it to fail to find sufficient partners willing to join it in coalition government and so it won’t get the chance to implement its destructive policy preferences. Elsewhere, while the main far-right parties will also significantly increase their shares of the vote in France in the spring and Germany in the autumn, we expect centre-right establishment candidates to prevail, with former Prime Minister François Fillon to win the French Presidency and Angela Merkel to win a fourth term as German Chancellor. And so, while we expect governments in each of the five largest member states to be relatively weak and financial markets to continue to be distracted by temporary episodes of political noise, in the coming year the euro area should manage to avoid a new lasting and damaging Brexit-like shock.
*This article was originally written for and published in Japanese by NNA Europe (http://europe.nna.jp)