Global Daily – Our conviction in a PEPP step up remains high

by: Nick Kounis , Aline Schuiling

ECB View: TLTRO cut a positive step but size of asset purchases not large enough – The ECB has announced (see here) a further reduction in the TLTRO lending rate. The rate has been cut by an additional 25bp and now stands at 50bp below the average refi rate over the period (so -0.5%) and 50bp below the deposit rate (so -1%) for counterparties that meet the lending performance threshold (see here). This a very important step and will be more effective in easing bank lending conditions than further cuts in the deposit rate. Meanwhile, the ECB announced a new series of operations – non-targeted pandemic emergency longer-term refinancing operations (PELTROs) – which will run between May 2020 and maturing in a staggered sequence between July and September 2021 to support liquidity conditions (see here). The maturities of the operations vary, starting with a tenor of 16 months in the first operation and ending with a tenor of 8 months in the last one. The PLTRO lending rate will be 25 bp  below the average refi rate over the period. The PLTRO has no conditionality in terms of lending benchmarks and could turn out marginally cheaper for banks that would fall short of these targets. Finally, the ECB left the size of its asset purchase programmes unchanged, against our expectations for a step up already at today’s meeting.

We continue to think that the ECB will increase the size of the PEPP by EUR 500bn. This now looks likely by the June Governing Council meeting or before. First, the Governing Council continues to signal that it is ‘is fully prepared to increase the size of the PEPP and adjust its composition, by as much as necessary and for as long as needed’. In the press conference, ECB President Lagarde added that the central bank was constantly evaluating the situation and its tools and specifically whether they were ‘sized properly’. She asserted that the ECB was more ‘determined than ever’ and stressed over and over again that the central bank would use all the flexibility it had, including in (remove the word in) the composition of its purchases to fight against fragmentation (ECB speak for closing spreads). Furthermore, she signalled the PEPP could be extend into 2021 if necessary.

Second, despite the current level of macro stimulus, inflation looks likely to very significantly undershoot the ECB’s inflation goal over the coming years. Indeed, the risk of deflation is rising. In the press conference following the decision, Ms Lagarde was more nuanced on the inflation outlook. She noted that ‘the sharp downturn in economic activity is expected to lead to negative effects on underlying inflation over the coming months. However, the medium-term implications of the coronavirus pandemic for inflation are surrounded by high uncertainty, given that downward pressures linked to weaker demand may be partially offset by upward pressures related to supply disruptions’. The ECB will publish a macroeconomic outlook scenario document tomorrow. We think that the demand shock is dwarfing the supply shock and hence there will be significant downward pressure on core inflation in the coming quarters (see below).

Third, government bond supply is surging and we think that the current level of purchases is insufficient to mop this supply up. Without a step up, financial conditions could tighten further. The Eurosystem’s net asset purchases this year will be EUR 1.1 trillion. Additional net asset purchases in response to the corona virus shock amount to EUR 870bn. Of this, we assume around EUR 540 will be government bonds. This will be insufficient to mop the extra government bond supply, which we estimate to be around EUR 850bn this year. A step up in the PEPP of EUR 500bn would be equivalent to roughly EUR 320bn in government bond purchases, taking total additional government bond purchases to EUR 860bn. That would then be enough to mop up additional government bond supply under our base scenario. (Nick Kounis & Aline Schuiling)

Euro Macro: GDP plummets in Q1, next quarter will be worse – The first estimate for Q1 GDP in the eurozone showed it contracted by 3.8% qoq, which was roughly in line with the consensus and our own forecasts. The contraction obviously reflects the fact that around mid-March all individual eurozone countries had imposed lockdowns to limit the spreading of the corona virus. Details of GDP have not yet been published for the eurozone, but France has already published a detailed Q1 GDP report, which gives us a clue where the weakness was concentrated. Still, we have to bear in mind that France was one of the first countries to put the economy in full lockdown and its lockdown measures were very strict compared to some other countries. In France (GDP -5.8% qoq in Q1) private consumption dropped by 6.1% qoq and fixed investment by 11.8%. Net exports reduced growth by 0.2pps. The only component of GDP that contributed positively to growth was inventory building (+ 0.9 pps). On the production side of the economy, construction dropped the most (-11.6% qoq), while manufacturing fell by 5.8%, market services by 5.7% and non-market services by 2.1%. France’s data probably are indicative for the eurozone as a whole. Looking ahead at Q2, it is essential to note that the lockdowns have continued throughout April in most countries, or even somewhat longer (e.g. France). Meanwhile, a number of countries have eased their lockdown measures a bit, while others have not. For instance, Spain has  allowed parts of industrial and construction workers to go back to work as from mid-April onwards, while in Germany parts of car production restarted around mid-April. However, Italian industrial workers will only be allowed to go back to work on 4 May. In any case, GDP is expected to contract even more in Q2 than in Q1. Besides France, a number of individual countries published Q1 GDP data today. Each national statistical bureau mentioned that the numbers are surrounded by a lot more uncertainty than normal and that the first estimates will probably be revised significantly at a later stage. In any case, Spain’s Q1 GDP contracted by 5.2% qoq, Italy’s by 4.7%, Belgium’s by 3.9% and Austria’s by 2.5%. (Aline Schuiling) 

Core inflation returns to levels below 1% – HICP inflation in the eurozone declined in April, falling to 0.4%, down from 0.7% in March. The main factor driving inflation lower was energy price inflation, which dropped to -9.6%, down from -4.5% in March. Working in the opposite direction, food price inflation rose, particularly fresh food price inflation, which jumped to 7.7%, up from 3.6% in March. Excluding the prices of energy, food, alcohol and tobacco, core inflation declined from 1.0% in March to 0.9% in April, reaching a level that is less than half the ECB’s medium term inflation target of close to 2%. Looking forward, the collapse in oil prices since the outbreak of the coronavirus will put further downward pressure on inflation in the coming months. Consequently, HICP inflation will probably register a few negative numbers on a year-over-year basis during Q2 of this year, before bouncing back later in the year. In the meantime, core inflation is likely to slow significantly in coming quarters. Given the weakness in demand, we expect core inflation to drop to around 0.5% by the end of next year. (Aline Schuiling & Nick Kounis)