- Financial conditions in the eurozone are tightening…
- …reflecting a shrinking liquidity surplus and stronger euro…
- …and increasing the chances of further ECB easing next year
- On the agenda: we expect the Fed to stay on hold, but signal a path to tapering
Tighter financial conditions in the eurozone…
Monetary conditions in the single currency area are tightening, which in our view is unwelcome from the perspective of the weak economic recovery and very low inflation. The tightening is coming from two sources. First of all, liquidity in the financial system is becoming less plentiful, leading to some upward pressure on interbank rates. This might, to some extent, be a ‘year-end’ effect. However, commercial banks have also continued to make substantial early repayments of LTROs. The ECB announced that commercial banks would repay EUR 22.7bn this week, which is the largest since February of this year. This could take the liquidity surplus in the system down to around EUR 130bn. If it falls below EUR 100bn, this would likely put significant further upward pressure on short rates. A tough treatment of commercial bank holding of bank bonds, financed in some cases by LTRO funds, could make repayments more attractive. The rise in short rates has also pushed up the short end of the yield curve and consequently the euro. Indeed, the euro trade-weighted index has risen by more than 6% this year (see chart). On the basis of purchasing power parity, the euro is overvalued versus most major currencies such as the Japanese yen (33%), US dollar (19%), Swedish krona (31%) and Norwegian krona (11%). Only the New Zealand dollar, the Swiss franc and the Australian dollar are overvalued versus the euro. The strength of the euro is a negative for exports and a direct disinflationary force, as it pushes down import prices.
…could trigger ECB action
We think that these developments could trigger ECB action if they are sustained. Governing Council members have signalled that they are ready and willing to act to keep conditions in the money market consistent with the desired monetary policy stance and to fight downside risks to inflation. A range of instruments is available and the choice of policy tool will depend on the situation. To push short rates back down (and as a consequence the euro) the ECB could pump more liquidity in the system by stopping the sterilisation of the SMP programme. This would add EUR 180bn to the liquidity surplus. Alternatively, it could cut policy rates further.
Fed tapering a close call – we expect no change combined with a signal of path to tapering
This week all eyes will be on the FOMC, with the big question being whether it will decide to reduce the pace of its asset purchases. We think that the decision will be a very close call. On balance, we think that the Fed will decide not to reduce the pace of its asset purchases. The case for no change is that the Fed Chair-elect Janet Yellen has set the bar very high for tapering, saying she wants to see ‘a very strong recovery’. Even though the activity data are quickly improving, there might be a bias to being absolutely sure. Similarly, on the labour market side, the nonfarm payrolls and unemployment paint a positive picture, but some of the other indicator Ms Yellen follows (labour market participation, the hiring rate and the quit rate) have been less impressive. Finally, inflation is very low, so the Fed can afford to wait. However, the need for clarity is becoming increasingly important and therefore we also expect the Committee to give a clear signal about the path to tapering its asset purchases, which looks likely to finally begin at the start of next year. At the same time, it will remain focused in keeping short-term interest rate expectations anchored. Crucially, we think that tapering is largely priced in to the Treasury curve. So although we see a further steepening of yield curves during the course of next year as the economy strengthens, in the near term we think that the tapering story has to a large extent been digested.