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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. 1 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. 2 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). 3 Eurozone: ECB challenged by higher bond yields 16 November 2016 Recent Research TW: 7 likely outcomes in 2017 15 Nov 16 Global: revenge of the demographic dividend 14 Nov 16 US: structural interest rate compression 2 Nov 16 FX: mid-quarter update 1 Nov 16 SG: down but not out 1 Nov 16 Rates: global rates roundup 31 Oct 16 TW: diversifying into Southeast Asia 21 Oct 16 CN: cyclical bottom 19 Oct 16 IN: assessing current account improvement 18 Oct 16 PHgov bonds: expensive (still) 11 Oct 16 CN: why falling private investment growth is a worry 12 Aug 16 ID: tax revenues slipping 11 Aug 16 SG: labour market pain 10 Aug 16 IN: monetary policy in transition 8 Aug 16 FX: DM vs EM - a more balanced story 1 Aug 16 Rates: Global rates roundup / chart-pack 1 Aug 16 IN: hopes high for GST 26 Jul 16 JP: will the helicopters fly? 20 Jul 16 ID rates: steepening risk 18 Jul 16 IN: more consumption-led growth 13 Jul 16 SGD: sticking to neutral 7 Oct 16 FX: revisions to GBP & JPY 8 Jul 16 EZ: not taper time yet 7 Oct 16 TW & KR: how low can rates go? 7 Jul 16 CN: avoiding the Minsky moment 6 Oct 16 US: a risky mantra 4 Jul 16 IN: monetary policy committee lowers rates 4 Oct 16 PH: Duterte’s game plan 4 Jul 16 15 Sep 16 EZ: dealing with post-Brexit blues 30 Jun 16 CNH: SDR inclusion - right time, right place 8 Sep 16 SG: Brexit impact limited for now 28 Jun 16 IN: savings rate in need of a boost 2 Sep 16 Britain’s Great Leap Backward 27 Jun 16 IDR: towards further resilience 1 Sep 16 Brexit – first impact 24 Jun 16 IN: maturing FCNR (B) deposits a molehill, not a mountain 10 Jun16 Qtrly: Economics-Markets-Strategy 3Q16 9 Jun 16 Qtrly: Economics-Markets-Strategy 4Q16 SGS: on Fed watch 30 Aug 16 Global growth: redefining strength 26 Aug 16 TW: 5 things you need to know about the aging population 18 Aug 16 SG: risks beneath the GDP figures CN: the risk of keeping status quo HK: cautious outlook 27 May 16 18 Aug 16 IN: monitoring external fault lines 25 May 16 17 Aug 16 TH: manufacturing gone cold 25 May 16 Disclaimer: The information herein is published by DBS Bank Ltd (the “Company”). 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