Global Daily – ECB Preview: Gradual dovish shift

by: Nick Kounis , Aline Schuiling , Bill Diviney

ECB view: Downgrades likely but it may take time for a change in scenario – We think that there will be a significant dovish shift in the ECB’s tone and forward guidance over the coming months, but this will probably only happen in steps, with the coming meeting representing the first modest step. At the upcoming meeting we expect the following:

(1)    Moderate reductions in economic growth and inflation forecasts. The ECB seems to be sticking to its base case for the economy and blames much of the weakness on temporary factors. In addition, in recent commentary, ECB officials seem to be holding on to the idea that underlying inflationary pressures will build significantly. However, we see room for more significant downgrades in the first half of next year as economic data make it clear that there is a more fundamental export-led slowdown in train (for more on the projections, please see below).

(2)    Unchanged guidance on policy interest rates. In line with the view that the ECB will largely stick to its base case for the economic outlook, it will unlikely alter its forward guidance on policy rates next week. We expect a change in the forward guidance to come by June of next year, when the Governing Council will signal that it expects policy rates to remain unchanged at least through 2019.

(3)    End of net purchases but clearer guidance on reinvestments. We think that the ECB will almost certainly announce that it will end net asset purchases this month. Given that purchases for a number of countries are constrained by issue(r) limits it cannot continue in any case. However, it may provide more information about its reinvestment policies. For instance, it may imply a longer period of reinvestments, by stating they will continue ‘well past’ the period of unchanged policy rates. In addition, it may give itself more flexibility to reinvest the proceeds of maturing securities within a longer time frame than the subsequent two months as currently the case.

(4)    No announcement yet on TLTROs. We do not think the ECB is ready to announce any changes to the TLTRO programmes. Discussions appear to still be at an early stage. We expect changes to the TLTRO programme in March, to allow banks to repay the funds over a longer period than currently.

Updated growth and inflation projections – The ECB will publish its new staff macroeconomic projections as well as extending its forecasting horizon by one year to 2021. In its September projections the central bank forecast GDP growth of 2.0% in 2018, 1.8% in 2019 and 1.7% in 2020. Since the publication of the September forecasts, economic conditions in the eurozone have clearly deteriorated. For instance, the manufacturing and services PMIs, business confidence and consumer confidence have all  dropped. Meanwhile hard economic data such as growth in the volume of retail sales and industrial production has also deteriorated and the unemployment rate has stopped falling since July. Moreover, according to preliminary data published a few days after the ECB’s October Governing Council meeting, GDP growth declined from 0.4% qoq in Q2, to 0.2%in Q3. Although industrial production and car sales were temporarily hit by problems in the car sector in Q3 (which should be followed by bounce back at a later stage), trade data and global PMIs suggest that slower exports growth has limited growth more persistently, and will continue to do so in the coming quarters. Finally, financial conditions have tightened since the publication of the ECB’s September projections, largely because of a decline in equity prices and a rise in corporate financing costs. On a more positive note, oil prices have dropped in recent months, which will have a positive impact on economic growth in the eurozone. Adding everything up, we think the ECB will eventually have to revise its growth forecasts lower by around 0.1-0.2pps for 2018, around 0.4 pps for 2019 and 2020. However, considering the ECB’s recent commentary, this will happen in smaller steps.

With regard to the outlook for inflation, the drop in oil prices (for which the technical assumption will be made that they will remain stable at a lower level) will probably result in a downward revision of the ECB’s projections for headline inflation. The current forecasts are that headline inflation remains stable at 1.7% in 2018, 2019 and 2020. The projections for 2019 and 2020 will probably decline by 0.2 pps. In line with the tradition the initial forecast for 2021 will probably be around 1.8%. More interesting to watch will be the change in the ECB’s forecast for core inflation. The worsened outlook for economic growth, unemployment and wage growth, should result in a downward revision of the forecast for core inflation. Important in this respect also is that the unemployment rate has remained stable at  a rate of 8.1% since July, which is still well above the pre-crisis lows of 7.2%. The ECB’s September projections for core inflation are 1.1% in 2018, 1.5% in 2019 and 1.8% in 2020. We think the worsened growth outlook implies that the forecasts for 2019 and 2020 should be lowered by around 0.3pps eventually. Although, similar to the projections for GDP growth, the ECB will likely do this in smaller steps.

Our base case for the ECB – We expect the ECB to keep interest rates on hold next year. We expect a 10bp hike in all the policy rates in March 2020 and a second 10bp increase in September 2020 (with all policy rates moving in synch). We do not expect the ECB to end reinvestments until late in 2021. Finally, we expect a TLTRO extension to be announced in March 2019.  (Nick Kounis & Aline Schuiling)

US Macro: Leading growth indicators are still looking strong – While we expect growth momentum to slow significantly over the coming quarters, the macro data in the US continues to suggest an economy growing at pace that is well above potential. Following the strong November ISM manufacturing PMI earlier in the week, which showed a surprise rebound in the new orders index, the non-manufacturing PMI also showed a surprise pickup to 60.7 – the second-highest reading since 2005. Consistent with the manufacturing PMI, the rise was driven by the new orders index, which bodes well for near-term growth prospects. There are pockets of softness in the US economy (for instance housing), and we think on balance growth momentum is currently peaking – driven by a turn in the investment cycle, fading fiscal stimulus, and the lagged pass-through of Fed tightening. However, in the near term at least, the economy looks to remain on a very solid footing. (Bill Diviney)