Global Daily – Changes to our ECB and Fed scenarios

by: Nick Kounis , Aline Schuiling , Kim Liu , Georgette Boele

ECB View: Slower exit expected – We expect the ECB to wind down its QE programme next year, but at an even slower pace than previously expected. We now think that the ECB will half the pace of its monthly net asset purchases from January onwards (to EUR 30bn from 60bn) up to September of next year, subsequently ending net asset purchases altogether. The first interest rate hike will not come until 2019. Previously, we expected the ECB to wind down purchases in 6-months and to hike already in September of 2018. The strength of the economic recovery and limits to its QE programme mean that the ECB should wind down the programme next year. On the other hand, concerns about further euro strength and still subdued underlying inflationary pressures mean that the exit process will be very slow. The key communication challenges for the ECB will be to contain market expectations that September will necessarily be the last month of QE, as well as convincing investors that rate hikes are an even longer way off. The ECB’s main objective is to move towards the exit without causing an early tightening of financial conditions. Though we do expect to see further euro strength and some rise in bond yields – see below – we do not expect a tantrum. (Nick Kounis)

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Euro Macro: Upward revision of our GDP growth forecasts – We have revised our forecasts for eurozone GDP growth in 2017 and 2018 higher (from 2.1% to 2.3% and from 1.8% to 2.2%, respectively). We expect growth in domestic demand to pick up somewhat as fixed investment strengthens and consumption continues to grow solidly. Also financial conditions are expected to remain supportive to domestic demand. Moreover, we no longer see the global economy slowing down in the coming quarters, which should stimulate exports. These factors should compensate for the downward impact on foreign trade resulting from the stronger euro. Despite the upward revisions to our growth outlook we have not made any significant adjustments to our inflation scenario (headline inflation 1.5% in 2017 and 1.3% in 2018). Although unemployment will probably continue to steadily decline, it will probably take a while for it to fall to levels where the labour market is tight enough to generate wage inflation. In addition, the strength of the euro will curb import price inflation. We do not expect a clear upward trend to be visible in core inflation until during the course of next year. (Aline Schuiling)

Fed View: Longer pause – We no longer expect the Fed to hike in December and expect the FOMC’s next move to be in March of next year, marking a prolonged pause in the rate hike cycle. This reflects that recent weak inflation data have created uncertainty at the Fed about whether inflation will move back to its target over the medium term. Indeed, we think US core inflation will stay low for longer. Shelter cost inflation – which had been a source of upward pressure previously – has slowed as the mortgage market recovers, which limits rents. In addition, underlying inflationary pressure from the labour market remains weak and competition in the mobile communications sector has also been a drag. In the near term, core inflation will slow further. In addition, we think at least five out of the nine voting FOMC members want to take a wait-and-see stance in terms of inflation. Overall, we previously expected three 25bp hikes to the end of 2018, we now expect only two. Our base case remains that the Fed will embark on a gradual process of balance sheet reduction from Q4 onwards. (Nick Kounis)

Global Rates: More modest rises in bond yields – We expect government bond yields to rise modestly in the coming months, with euro yield curves steepening, as the ECB reduces stimulus and the economic environment continues to improve. However, ongoing low inflation and only a very slow exit from super accommodative policy should be a factor limiting the rise. Indeed, given our changed expectations on monetary policy, we expect yields to rise more moderately than we previously did. We previously expected that the 10y Bund yield would reach 0.80% at the end of 2017, we now expect the yield to increase to 0.60%. For next year, we expect a very flat trajectory in the 10y Bund yield as it will increase only slightly to 0.80% at year-end. The balance of risks to our eurozone bond yield forecasts remain tilted to the downside. Furthermore, we expect US 10y Treasury yields to continue to gradually move higher as the Fed slowly normalises short-term interest rates. The market is currently pricing in only one hike for next year so our scenario implies a modest upward adjustment in Fed rate hike expectations. Still given the change in our Fed view, the uptrend in US yields is now expected to be more moderate. As such, we have revised our forecast for 10y UST down to 2.20% for the end of this year and to 2.5% for the end of 2018. (Kim Liu)

Global FX: Higher EUR/USD seen – We have increased our year-end EUR/USD forecast to 1.20. In the near-term net-long position liquidation will probably push EUR/USD towards 1.15 but later in the year we expect EUR/USD to move back to 1.20. We also increased our 2018 year-end target from 1.20 to 1.30. We expect the ECB’s shift to less accommodative monetary policy to support the euro in the coming 14 months, just as the Fed’s gradual exit from QE provided support to the US dollar in the past. We expect US dollar sentiment to remain negative for now. First, we have lowered the number of Fed rate hikes to two for the coming 14 months. This is closer to market expectations but below that of the Fed. Second, the domestic political situation and the geo-political uncertainty will continue to dent sentiment towards the US dollar barring a panic in financial markets because that will result in safe-haven demand for the US dollar. Third, the long term trend has turned negative for the US dollar this year. This mean it is likely that the dollar has started a multi-year decline. In such an environment speculative investors will probably sell the US dollar on rallies. However, the upside in EUR/USD will likely be dampened somewhat (less steep rise as seen in 2017) as the Fed reduces its balance sheet. In short, our new EUR/USD forecasts reflect more US dollar weakness and more euro strength at the same time. (Georgette Boele)