Download Eurozone: ECB challenged by higher bond yields

Eurozone: ECB challenged by higher bond yields
16 November 2016
Economics
Eurozone: ECB challenged by higher
bond yields
DBS Group Research
16 November 2016
• The European Central Bank is challenged by the latest rise in US bond
yields on Trump-led reflation expectations
• EU rates were not spared from rising global yields, which in turn, has
raised doubts over the ECB’s quantitative easing program
• There is sufficient justification for the ECB to extend the QE program
and moderate its quantum of asset purchases
• The hurdle to step-up fiscal spending remains high in spite of the
trend towards fiscal over monetary stimulus in lifting growth
Rising US bond yields and reflation expectations have put the European Central
Bank (ECB) in a bind. Promises of a surge in public spending by incoming US
President-elect Donald Trump have stoked expectations that US growth will
get a leg-up, accompanied by a lift to inflation.
Mirroring the surge in US yields, the EU 10Y bond yield has risen to 0.30% on 15
Nov from 0.19% on 8 Nov. More importantly, this yield has ceased to be negative since early-October. Over the past week, expectations have increased for
fiscal stimulus to overtake monetary policy in supporting growth.
Against this backdrop, the ECB will need to provide clarity on their policy guidance. In the past week, policymakers reiterated their dovish stance to temper
the rise in bond yields (and borrowing costs), so not to blunt efforts to stimulate the economy.
Chart 1: Ten-year bond yields - G3 economies
% pa
2.5
2.0
1.5
Japan
1.0
Eurozone
US
0.5
0.0
-0.5
Nov-15
Feb-16
May-16
Aug-16
Nov-16
Radhika Rao • (65) 6878-5282 • [email protected]
Refer to important disclosures at the end of this report.
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Eurozone: ECB challenged by higher bond yields
Chart 2: Core 4 (GE, IT, SP, FR) GDP growth
16 November 2016
Chart 3: Headline and core inflation
%
YoY, %
4.0
2.4
3.0
2.0
1.6
2.0
1.2
1.0
ECB inflation
target
0.8
0.0
0.4
-1.0
QoQ saar
0.0
-2.0
4Q mvg avg
0.4
-3.0
Mar-10
CPI
Core CPI
Mar-13
Mar-16
0.8
Jan-14
Jul-14
Jan-15
Jul-15
Jan-16
Jul-16
What are the data telling us?
Growth has stabilised this year, even if modestly lower (Chart 1). Headwinds
on the horizon continue to pose downside risks. Progress on the ECB’s primary
mandate to maintain price stability, meanwhile, has remained slow.
From 2.0% last year, GDP growth in 1Q-3Q16 has slowed to 1.6% YoY. Authorities remain watchful of downside risks from Brexit developments, slower
China/Emerging Market growth and potential protectionist trade policies out
of the US.
Domestic factors continue to support the Eurozone economy. Consumption is
benefitting from easing unemployment rates and low inflation. The modestly
wider fiscal deficit in 1Q16 may be signalling a let-up in fiscal austerity. After
treading water in 3Q16, private sector activity appears to be on a firmer footing in 4Q16. Production gained some ground in 3Q16 on durables output, but
pricing power remains soft despite better margins (due to low input prices).
External factors are, however, less favorable. Exports and imports extended
their declines. Support from exogenous factors such as low oil prices, a weak
euro and easy monetary policy are also likely to wane. These factors will keep
growth this year and the next at 1.6%, down a notch from 2015. Downside
risks are likely for 2017, contingent on the timing of Brexit and key elections in
France and Germany.
Separately, inflation rose to 0.5% YoY in Oct16 from June’s 0.1% on higher
energy prices and base effects (Chart 3). Yet, inflation averaged only 0.1% in
Jan-Oct16, up marginally from 0% last year. Core inflation continued to stagnate within 0.7-0.8% from supply side-pressures such as excess capacity and
weak wages.
Overall, growth has stabilised but remains vulnerable to any unexpected deterioration in the external environment. Inflation, on the other hand, is beginning to stir but achieving the 2% target remains elusive without a sustained
revival in supply-side forces.
Watch ECB closely
The central bank’s official rhetoric thereby warrants close attention. Any attempts to play down prospects of a swift recovery in growth and inflation will
reinforce expectations of further stimulus. But, the authorities will be mindful
of not stoking market expectations (after last December’s experience), hence
the stance will be crafted carefully without being overtly committal.
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Eurozone: ECB challenged by higher bond yields
16 November 2016
We maintain our view that an extension of the QE program beyond March
2017 is likely to be announced in December or early 1Q17. While we expect
the quantum of purchases to stay at EUR 80bn a month [1], we also see the
risk of the purchases returning to its previous pace of EUR 60bn. Tweaks to the
purchase criterion are also in the works. Here, the lift in EU bond yields has
expanded the pool of eligible assets available for QE purchases. With the US
Fed on a normalisation path, an accommodative ECB will also keep euro gains
in check.
On the whole, the ECB will not be contemplating an abrupt end to its QE program when it expires in Mar 2017. With the recovery fragile and vulnerable to
market volatility, in particular, to abrupt rises in borrowing costs, a gradualist
approach to withdrawing monetary stimulus will be preferred.
High hurdles for fiscal stimulus
To balance the increasing constraints on monetary policy, the ECB is likely to
push for more fiscal and reforms support to boost growth. Encouragingly, the
bloc-wide fiscal deficit met the Maastricht treaty last year, narrowing to -2.1%
of GDP from its peak of -6% in 2009-10.
At the start of this year, there are signs that the fiscal stranglehold is being
loosened. 1Q16 deficit re-widened to -3.1% of GDP, accompanied by a slight
deterioration in the primary deficit (excluding interest payments). Hence pressure will remain on economies with the available fiscal space, particularly Germany, to step-up spending to meet rising refugee needs, security and infrastructure requirements. The other highly indebted EU economies are likely to
be given more time to adjust their books.
A looser fiscal stance will, however, need to be balanced with containing the
overall public debt levels and preventing them from becoming flash-points for
the bloc again. While the US might step up fiscal spending, the hurdles to scale
up stimulus in the Eurozone remain high given the lessons learnt from 2011-13
sovereign debt crisis.
Apart from the policy direction, the ECB is also likely to watch out for key event
risks such as the Italian referendum, Greek bailout negotiations, banking sector concerns, and upcoming elections in Germany/ France.
In summary
The shift in US dynamics and resultant contagion impact on the Eurozone bond
yields/euro leaves the central bank in a bind.
We expect the ECB to keep its rhetoric dovish and announce an extension in
the QE purchases at the December meeting. The differentiating factor however will be the quantum of purchases, where we now expect a modest cutback.
This will be in line with the stable growth momentum and the recent uptick
in inflation which is still way below targets. A push for more fiscal support will
continue, but the precedent of high sovereign debt levels and resultant crisis,
raises the hurdle for a looser fiscal policy.
Notes:
[1] DBS Group Research; “Eurozone: not taper time yet”; 7 October 2016
Sources:
Data for all charts and tables are from CEIC, Bloomberg, government, central banks
and DBS Group Research (forecasts are transformations).
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Eurozone: ECB challenged by higher bond yields
16 November 2016
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