ECB review: less ‘punch in the bowl’ from Draghi

ECB review: less ‘punch in the bowl’ from DraghiPernille Bomholdt Henneberg Anders Møller LumholtzSenior Analyst, Euro area macro Research Chief Analyst, Fixed Income Research+45 45 13 20 21/+44 20 7410 8157 +45 45 14 69 [email protected] [email protected]

Thomas Harr Thomas Hoppe RosenlundGlobal Head of FICC Research Graduate, Fixed Income Research+45 45 13 67 31 +45 45 14 32 [email protected] [email protected]

8 December 2016

Investment Research

www.danskemarketsequities.com Important disclosures and certifications are contained from page 17 of this report.

11

The ECB extended its QE purchases by nine months to December 2017, but reduced the

monthly purchases to EUR60bn from EUR80bn. The lower pace of purchases followed,according to the ECB, as the risk of deflation has now largely disappeared (the reason why thepace of purchases was temporarily lifted). President Draghi said the nine-month extensionfollowed, as the ECB wants to signal a sustained presence and no near-term tapering.

Draghi expressed a very dovish tone during the Q&A and continued to repeat that tapering

had not been discussed. According to Draghi, none of the ECB members want to taper QE, butthe main message was a sustained ECB presence in the markets without distortions. Relatedto this, the ECB communicated additional flexibility in case of a less favourable inflation outlookor a worsening in financial conditions.

The market seemed to ‘accept’ that the lower QE purchases do not imply the ECB is on a

tapering path. This should be seen in light of Draghi’s dovish stance including the commentsthat the new inflation projection is ‘not really’ close to the 2% target and that the ECB does nothave the ‘luxury’ to consider lowering its purchases further.

In terms of QE restriction changes, the ECB now permits buying bonds with a yield below the

deposit rate while the maturity range includes the 1-2y. The ECB has thus not lifted the 33%issue/issuer limit and will continue to follow the Capital Key distribution. On the repoadjustments, the ECB headlines indicate substantial easing – the details are less upbeat.

ECB review: less ‘punch in the bowl’ from Draghi

22

Looking ahead, we still believe the ECB will announce a third QE extension some time in H2

next year. This should follow as we do not believe inflation will reach a sustained path consistentwith the inflation aim before December 2017. Draghi said the inflation projection at 1.7% in2019 is ‘not really’ close to the 2% target, implying another extension is likely if the ECB revisesits inflation forecast lower again. We still consider the ECB’s core inflation projection veryoptimistic and based on this a lower inflation projection should eventually follow.

The QE extension of EUR60bn for nine months was less than the market had expected,

triggering a fixed income sell-off. The short-end rallied after Draghi opened the door for thepossibility of ‘buying below depo’. Overall, the 2/30 in Germany steepened 10bp. The fact thatthe issue/issuer limit was kept unchanged means purchases in Ireland and Portugal are set todecrease further (deviate more) from what the Capital Key would have suggested. Portugalwidened 20bp to core, while the market reaction in Ireland was more muted.

EUR/USD initially bounced on the ECB announcement but fell thereafter when the market

realized that the policy change was in a more dovish direction than it initially appeared. At thepress conference, Draghi clearly struck a dovish tone, stressing that sustained ECB presencein markets is the main message. Near term, we see EUR/USD in a 1.05-1.10 range with thebalance of risks skewed towards a break to the downside. As such, EUR/USD is a sell on rallieswithin the 1.05-1.10 range. We forecast EUR/USD at 1.05 in 1M and 1.04 in 3M before asustained move higher to 1.08 in 6M and 1.12 in 12M.


33


1. QE extension at a slower pace, but this is NOT tapering

2. We expect a third QE extension in H2 17 as inflation is set to stay low

4. Repo adjustment details might be less upbeat than the headline

3. Restriction changes: steeper DE curve – less support to PT + IE

5. Inflation projection at 1.7% in 2019 is ‘not really’ close to the 2% target

44

No members want to taper QE: QE purchases at EUR60bn – not ending soon

QE purchases back at EUR60bn as risk of deflation is lower

The ECB extended its QE purchases by ninemonths but at a slower pace of EUR60bn vsEUR80bn previously. Despite the slowerpace, it adds QE purchases of EUR540bn,which is more than consensus of EUR480bnwhich would have followed from a EUR80bnextension for six months.

Draghi made it very clear that this is nottapering – tapering is not even on the table asno members want to taper QE. Instead, it is away to signal that the ECB will have asustained presence on the markets.

Additionally, the ECB communicated it isflexible in case of a less favourable outlook ora worsening in the financial conditions. Thelatter could in our view e.g. follow fromincreased political uncertainty.

Source: ECB, Danske Bank Markets

#1 QE extension at a slower pace, but this is NOT tapering

0

10

20

30

40

50

60

70

80

90

Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18

Potential additional QE extensions ECB announce QE extension (December)

Current QE programme

EUR bn Monthly QE purchases

?

55

ECB rate hikes still priced too aggressive: ECB pricing volatility during the day

The market is still pricing ECB rate hikes – this is premature

The market initially reacted to the nine monthextension of EUR60bn by pricing in a 10bpECB rate hike already in September 2018,but by day-end the rate hike was again pricedin end-2018, hence unchanged from goinginto the ECB meeting.

In our view, a rate hike within two years isstill very unlikely, as we believe the ECB willextend its QE purchases beyond December2017. The ECB’s communication that it isnot close to tapering makes the pricing of arate hike even more premature in our view.

The ECB still communicates that policy ratesare expected to stay at present or lowerlevels well past the horizon of the QEpurchases. The Fed waited 13 months fromending QE to hiking the first time.


-2

0

2

4

6

8

10

12

14

16

Dec-16 ECB

Mar-17 ECB

Jun-17 ECB

Sep-17 ECB

Dec-17 ECB

Mar-18 ECB

Jun-18 ECB

Sep-18 ECB

Dec-18 ECB

bp

13:00 13:46 14:15 14:33 16:00

ECB dated Eonia swaps (assuming neutral Eonia is 5bp above deposit rate)

Source: Danske Bank Markets

66

Inflation is only priced at 1.0% at end-2019 Lower real yields before ECB starts hiking

Still inconsistency between hiking cycle and inflation expectations

Source: Bloomberg, ECB, Eurostat, Danske Bank Markets Source: Bloomberg, Danske Bank Markets


-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19

HICP inflation Market pricing

ECB inflation forecast (December) Danske inflation forecast

The market is only pricing inflation at 1.0% ultimo 2019 vs. ECB's projection of 1.7%

77

ECB does not have ‘luxury’ to lower QE more: QE to be extended again given too low inflation

Inflation will not be on a sustainable path towards 2% in H2 17

According to Draghi, the ECB does not havethe ‘luxury’ of considering lowering its QEpurchases further, as the economic figuresare not currently strong enough for this.

Additionally, the ECB again argued there is noupward trend in underlying inflation. In ourview, this will continue for a long time as thewage pressure will remain weak, hencekeeping core inflation below the ECB’s updatedprojection.

Based on this, the ECB should not concludethat inflation is on a sustained path towardsthe 2% target at end-2017 and we believe itwill extend its QE purchases a third time,thereby continuing purchases beyondDecember 2018.


#2 We expect a third QE extension in H2 17 as inflation is set to stay low

88

Core inflation is far from the ECB’s forecast Philips curve: ECB’s wage forecast is hopeful

Lack of upward trend in core inflation is a concern to the ECB

ECB 2016Wages: 1.2%Unemp: 10.0%



Core inflation on a downwardtrend – ECB’s projectionremains very optimistic

Source: ECB, Eurostat, Danske Bank Markets Source: ECB, Eurostat, Danske Bank Markets



99

Service inflation most important for core Service inflation dependent on wage growth

No ECB QE tapering or rate hikes before wage growth picks up



1010

ECB can buy bonds yielding below -40bp: QE to be extended again… and again?

Buying below the deposit rate – only an option, not necessity

The ECB changed its QE restriction to nowpermitting purchases of bonds with a yieldbelow the deposit rate while the maturityrange will include the 1-2y, making a largeamount of German bonds eligible for QE.

The previous eligibility ‘cut-off’ point hasbeen hovering around the 5-6y mark on theGerman curve recently. Hence the QEchanges enable the ECB to buy the 1-6ysegment from January opening for Germanbond purchases for around EUR400bn.

However, this is only the case if the ECB buysall bonds yielding below the deposit rate. Weconsider this unlikely given the ECB said thatbuying below the deposit rate is an option –not a necessity.


#3 Restriction changes: steeper DE curve – less support to PT + IE

0

200

400

600

800

1000

1200

1400

-0.75%

-0.45%

-0.15%

0.15%

0.45%

0.75%

1.05%

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32

Yield

YearsGermany government bonds (live) ECB deposit rate

27/09/2016 German bonds acc. amount (r.axis)

1111

Less purchases in Portugal and Ireland: ECB has already reduced purchases in IE+PT

Portugal + Ireland and Buxl victims of the issue/issuer limit

#3 Restriction changes: steeper DE curve – less support to PT + IE

The ECB maintained its Capital Key purchasedistribution and also maintained the 33%issue/issuer limit on bond purchases. Inparticular, the latter is going to result inlower purchases of Irish and Portuguesebonds as has already been seen.

Based on this, we see risk tilted towardsIreland widening again vs for instanceFrance.

Purchases of longer-dated German bondsare also set to be reduced significantly as weenter 2017 and the QE holdings in +8YGermany approach the 33% issue limit. Itremains an open question whether the ECBwill be willing to buy large amounts belowdepo in this scenario and/or whether it coulddeviate from the capital key.

60

80

100

120

140

160

180

Mar

/15

Ap

r/1

5

May

/15

Jun

/15

Jul/

15

Au

g/1

5

Sep

/15

Oct

/15

No

v/1

5

Dec

/15

Jan

/16

Feb

/16

Mar

/16

Ap

r/1

6

May

/16

Jun

/16

Jul/

16

Au

g/1

6

Sep

/16

Oct

/16

Monthly PSPP purchases - index 2015 average

Total Supra FR FI DE

NE IE IT PT ES


1212

Limited ease of the squeeze in German repo: Big ‘squeeze’ where ECB has been aggressive

Repo adjustment – limited ease of the squeeze in German repo

#4 Repo adjustment details might be less upbeat than the headline


The ECB today opened for the new possibilityto use cash as collateral with the pricinglinked to the deposit rate. Cash can be usedas collateral up to an overall limit ofEUR50bn for the Eurosystem.

According to the ECB, the changes aim toenhance effectiveness of PSPP securitieslending and should be very welcome followingthe latest pressure on the German reposqueeze (most extreme from +7y).

However, looking at the details (see nextpage) this will, in our view, give only a limitedease of the squeeze in the German repo.

1313

The details are less upbeat than the headline: Big ‘squeeze’ where ECB has been aggressive

ECB should still be concerned about the squeeze in German repos

#4 Repo adjustment details might be less upbeat than the headline


The EUR50bn additional collateral which canbecome available should in isolation ease thesqueeze in the German repo.

However, the ECB statement also states theconditions will be at a rate equal to the lowerof the deposit rate minus 30bp (i.e. currently-70bp) and the prevailing market repo rate’.Hence, the -70bp will not be a floor butrather the cheapest level (ceiling) for where itwill be activated.

1414

Still no upward trend in core inflation data: ‘Not really’ close to the 2% target in 2019

The inflation projection for 2019 is not close to 2%

#5 Inflation projection at 1.7% in 2019 is ‘not really’ close the 2% target

The key argument for us expecting a third QEextension in H2 next year is that the ECBremains too optimistic on inflation, althoughthe projection for 2019 according to Draghiis ‘not really’ close to the 2% target.

The ECB is especially still very optimistic inits outlook for core inflation despite its viewthat there are ‘no signs yet of a convincing

upward trend in underlying inflation’. In ourview, the optimistic core inflation forecastfollows from a hopeful wage projection.

Despite the downward revision to the ECB’score inflation projection, we believe it will belowered again as core inflation will not reach1.4% in 2018 and 1.7% in 2019. This wouldimply headline inflation will be too far fromthe 2% target to end QE at the end of 2017.

Source: ECB, Eurostat, Danske Bank Markets

1515

Core inflation projection lowered too little The forecast has been lowered many times

A lower ECB core inflation projection but it is still too optimistic



1616

GDP indicators have been strong lately Not very high inflation projection in 2019

Stronger GDP growth but still not wage pressure to lift inflation


Source: Eurostat, Markit PMI, Danske Bank MarketsSource: ECB, Danske Bank Markets

ECB projections

(expected)2016 2017 2018 2019

HICP inflation0.3%

(0.2%)

1.2% (1.2%)

1.5%

(1.6%) 1.7%

Core inflation0.9%

(0.9%)

1.1% (1.3%)

1.4%

(1.5%) 1.6%

GDP growth1.6%

(1.7%)

1.6% (1.6%)

1.6%

(1.6%) 1.6%

Unemployment rate10.1%

(10.1%)

9.8% (9.9%)

9.5%

(9.6%) 9.2%

Wage growth1.2%

(1.2%)

1.5% (1.8%)

1.9%

(2.2%) 2.2%

Parenthesis are the old ECB's projections (from September)

ECB projections

(December 2016)2016 2017 2018 2019

HICP inflation0.2% (0.2%)

1.3% (1.2%)

1.5% (1.6%)

1.7%

Core inflation0.9% (0.9%)

1.1% (1.3%)

1.4% (1.5%)

1.7%

GDP growth1.7% (1.7%)

1.7% (1.6%)

1.6% (1.6%)

1.6%

Unemployment rate10.0% (10.1%)

9.5% (9.9%)

9.1% (9.6%)

8.7%

Wage growth1.2% (1.2%)

1.7% (1.8%)

2.1% (2.2%)

2.4%

Parenthesis are the old ECB projections (from September 2016)*Food price inflation is assumed higher in 2017-18

ECB projections

(December 2016)2016 2017 2018 2019

HICP inflation0.2% (0.2%)

1.3% (1.2%)

1.5% (1.6%)

1.7%

Core inflation0.9% (0.9%)

1.1% (1.3%)

1.4% (1.5%)

1.7%

GDP growth1.7% (1.7%)

1.7% (1.6%)

1.6% (1.6%)

1.6%

Unemployment rate10.0% (10.1%)

9.5% (9.9%)

9.1% (9.6%)

8.7%

Wage growth1.2% (1.2%)

1.7% (1.8%)

2.1% (2.2%)

2.4%

Parenthesis are the old ECB projections (from September 2016)*Food price inflation is assumed higher in 2017-18

1717

Disclosures

This research report has been prepared by Danske Research, a division of Danske Bank A/S (‘Danske Bank’). The author of this research report Pernille Bomholdt

Henneberg, Senior Analyst.

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ECB review: less ‘punch in the bowl’ from Draghi

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