ECB View: Central bank signals willingness to act and euro concern but plays down inflation numbers – The ECB struck a mixed tone in its press conference. On the dovish side, the Governing Council signalled that ‘it continues to stand ready to adjust all of its instruments, as appropriate, to ensure that inflation moves towards its aim in a sustained manner, in line with its commitment to symmetry’. In addition, it made it clear that the PEPP envelope would very likely be used in full. Finally, it highlighted that the strength of the euro was unwelcome in terms of its disinflationary impact. It referred to the euro explicitly in its opening statement, asserting that ‘the Governing Council will carefully assess incoming information, including developments in the exchange rate, with regard to its implications for the medium-term inflation outlook’. On the other hand, the Council did not discuss a further increase in the PEPP envelope at this stage. Meanwhile, it raised modestly its core inflation projection for next year (see below) and played down recent inflation numbers. President Christine Lagarde suggested that the fall in core inflation in August to a record low was entirely due to transitory factors and dismissed the risk of deflation. This seems a rather optimistic take to us. Indeed, the ECB continues to project relatively stable core inflation over the coming years, whereas in past crises we have seen drops of 0.75-1%. Against the background of rising unemployment and building slack in the economy more widely, it does not seem likely that this time will be different for core inflation.
Modest changes to projections – The ECB published its new staff macroeconomic projections. ECB economists made only small changes to their previous forecasts, while emphasising that the uncertainties surrounding the forecast are exceptionally high. President Lagarde also mentioned that the ECB still sees the risks to this outlook as being tilted to the downside. The central bank forecasts GDP to contract by 8% in 2020 and to grow by 5.0% in 2021 and 3.2% in 2022. The forecast for 2020 was revised upward, but those for 2021 and 2022 were revised somewhat lower.
The ECB’s forecasts for inflation were also kept largely unchanged, at 0.3% in 2020, 1.0% in 2021 and 1.3% in 2022. The core inflation rate is projected to be 0.9% in 2020, 0.8% in 2021 and 1.1% in 2022, so well below the ECB’s target of close to but below 2%. The forecast for core inflation in 2022 was revised upward from the June projection of 0.9%. This is surprising given its technical assumptions for the trade-weighted exchange rate of the euro. The ECB previously assumed an appreciation of 1.8% during 2020-2021. It now expects an appreciation of 6%, which would (all else equal) reduce underlying inflation by 0.1-0.2 percentage points.
Further policy easing still likely – We remain of the view that the ECB will ease policy again by the end of this year, most likely in December. Our base case is for a EUR 500bn increase in the PEPP envelope. In addition, given sharply increasing liquidity and the fall in money market rates, we judge that the ECB will increase the tiering multiplier in the coming months. This should provide a modest boost to bank profits. Finally, we remain of the view that the deposit rate will remain unchanged. However, a significant further rise in the euro could put a rate cut back on the table. (Nick Kounis & Aline Schuiling)
Euro Rates: Bund yields to move lower, country spreads higher – During the ECB press conference, the yields of core and semi-core government bonds increased on the back of the upward revision to the inflation forecast and a generally less dovish tone than expected. The increase in rates for the (semi)core countries and the swap curve was most pronounced in the belly of the curve, which resulted in bear steepening. However, the upward effect on yields of peripheral bonds was more than offset by President Lagarde’s comment that it is very likely that the full PEPP envelope will be used, putting downward pressure on peripheral spreads. As a result, outright yields of peripheral bonds decreased. Meanwhile, ASWs tightened for EGBs.
We think that Bund yields will move lower in coming months, as the economy will take a long time to recover, disinflationary pressures will build, while the ECB increases the PEPP envelope in our base case. Furthermore, the eurozone PMIs signalled in the start of a double-dip in growth in August. Likely more weak economic data will follow in the coming months. We expect core yield curves to flatten again in the near term and outright yields to remain deeply negative during our forecasting horizon.
Sovereign spreads are roughly now back at pre-corona levels on the back of the Recovery Fund and the Eurosystem’s support, but credit fundamentals have deteriorated drastically since the Covid-19 outbreak. Within the coming month(s), we expect a correction, hence a rise in spreads, triggered by disappointing macro data. Furthermore, we expect a more pronounced spread widening for peripherals than for core and semi-core. However, we continue to expect ECB purchases to cap the rise in sovereign spreads. (Jolien van den Ende & Floortje Merten)