ECB to commit to QE end despite Italy budget crisis, soft core inflation

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The European Central Bank (ECB) will be meeting in Frankfurt on Thursday and, while no change in policy is expected, investors will be watching closely for any clues as to the timing of the first interest rate hike in the Eurozone since 2011.  

 

News out of the Eurozone has been mixed since the last ECB meeting in September and risks to the outlook have, in our view, undoubtedly increased. The political turmoil in Italy has dragged the Euro lower and has led to a sell-off in equity markets and a sharp increase in Italian bond yields. The Stoxx Europe 600 index declined to its lowest level since December 2016 in October on the news that the new Italian coalition was targeting a budget deficit of 2.4%, considerably higher than that deemed appropriate by the European Union.

 

Official word from the European Commission in October that Italy’s draft budget was in ‘serious non-compliance with EU budget rules’ led to further decline in Italian bond prices, with the government’s 10-year bond yield rising sharply to a near five year high of close to 3.6%. The spread between Italian bond yields and their German equivalent, seen as a proxy for the level of risk inherent in investing in Italian assets, has jumped to its highest level since early-2013 (Figure 1). Global risks also remain elevated amid ongoing tensions in emerging markets. Likewise, the Brexit saga continues to drag on following the October EU summit that failed to deliver a final exit agreement.

 

Figure 1: Italian-German 10 Year Government Bond Yield Spread (2012 - 2018)

Figure1.png

Source: Thomson Reuters Datastream Date: 19/10/2018

 

Macroeconomic data out of the Eurozone has been mixed, although the two main indicators, the composite PMI and core inflation, have both surprised to the downside since the September ECB meeting. The stubbornly low level of core inflation, of which remains well below the ‘close to, but below’ 2% target, will be of particular concern to the Governing Council. Core inflation declined unexpectedly to just 0.9% in September after investors had eyed a modest upward revision (Figure 2). It is worth reiterating that this measure is the key to ECB decision making, with its return back to target the bank’s one and only primary objective.

 

Figure 2: Eurozone Inflation Rate (2013 - 2018)

Figure2.jpg

 

Source: Thomson Reuters Datastream Date: 19/10/2018

The latest composite PMI, one of the most important indicators of growth inout of the Euro-area economy, was also revised lower. The index declined to 53.1 last month, matching its lowest level since late-2016. There was, however, another decline in the overall unemployment rate and there have so far been no signs that uncertainty over global trade has had a negative impact on exports.   

 

Figure 3: Eurozone Macroeconomic Data Releases (since 13/09/2018)

Data Release

Month

Actual

Consensus

Previous

FX Impact

Consumer Price Index YoY

Aug

2.1%

2.1%

2.0%

EUR Positive

Consumer Price Index - Core YoY

Aug

0.9%

1.1%

1.0%

EUR Negative

Markit Composite PMI

Sep

54.1

54.4

54.5

EUR Negative

Markit Services PMI

Sep

54.7

54.4

54.4

EUR Positive

Markit Manufacturing PMI

Sep

53.3

54.4

54.6

EUR Negative

Unemployment Rate

Aug

8.1%

8.2%

8.2%

EUR Positive

Industrial Production MoM

Aug

1.0%

0.4%

-0.7%

EUR Positive


Despite the obvious increase in downside risks in the Eurozone in the past month or so, we think that recent developments are insufficient in order to force the ECB into reconsidering its current path of monetary policy. We expect President Mario Draghi to reiterate plans to end the bank’s large-scale quantitative easing programme at the end of the year, having announced the bank’s intention to wind down its asset purchases to zero back in June. It would, in our opinion, take a massive blow up in the Italian crisis or a significant financial market event in order to derail the central bank’s existing plans. Draghi may instead merely take on a slightly more dovish tilt on Thursday in light of these heightened risks, albeit we expect this to be largely priced in going into the meeting.  

 

As for the timing of the first interest rate hike, the key remains the upcoming prints of core inflation. We will be closing watching for any comments during Draghi’s press conference on the bank’s confidence that this measure will begin to trend towards target in the coming months. Draghi will likely be quizzed over his recent comments at the European Parliament where he stated that he saw a ‘relatively vigorous’ pickup in core inflation. In our view, his answers on the inflation issue will be the most critical part of the meeting and the main source of information driving currency volatility in the aftermath.

 

We remain of the opinion that the first interest rate hike could come in around the third quarter of 2019, although we think that this month’s meeting will be too early for any concrete hints from the ECB, particularly amid the recent aforementioned downside risks.  

 

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