BNY Mellon: Great Expectations

7 jan 2019

By Neil Mellor, Senior Currency Strategist, BNY Mellon

By Neil Mellor, Senior Currency Strategist, BNY Mellon

Although the ECB has formally ended its asset purchase program, the Bank will continue to reinvest funds from maturing assets ‘for an extended period of time’. And as a proviso against a backdrop of growing economic uncertainty, the potential significance of this declaration cannot be overstated.

Volatile energy prices have caused an oscillation in the eurozone’s annual headline rate of inflation in recent months, and this largely explained the drop to 1.6% (from 1.9%) in December.

But the core rate refuses to budge from the 1% marker where, give or take a tenth of a percentage point, it has stood for four long years. And of course, it is important to note here that this rate would be somewhat lower if it were stripped of its German contribution (1.6%).

Meanwhile, a more sober eurozone outlook may be taking hold: GDP growth fell by 0.2% q/q in Q3 and PMI data appear to suggest that the negative momentum continued through to year end.

Last week we learnt that Markit’s manufacturing PMI fell to a near three-year low in December – the report's despondency is in pointed contrast to its predecessors at the start of last year.

Then again, the ECB’s confidence that inflation will gradually rise is predicated on the absorption of what remains of the spare capacity resulting from the 2008 financial crisis.

However, suffice to say that the incidence of such constraints is far from even, and any reduction in stimulus this year, no matter how modest, would be premature for the numerous eurozone states that have made little headway in raising core inflation and lowering historically high levels of unemployment and debt.

Speaking of which, even if the Italian budget drama has ended, Italy’s fiscal problems have not: the government’s past dependence on ECB bond buying will leave it looking to fill a EUR 275 bn funding hole this year.

This may not even be the end of it given the ECB’s plans to align more closely with the capital key. And as we also learnt last week, weak growth and a weak loan book are seldom a good combination.

While enjoying a more stable position, Germany certainly has no immunity to slowing global growth.

The Bundesbank remains confident that the economy will overcome its latest slowdown irrespective of protectionism and Brexit-related risks that have helped to sink the ZEW sentiment gauge.

But Germany’s export-dependent economy is highly geared to China, whose slowing growth prompted the PBOC to slash banks’ reserve requirements on Friday.

Indeed, the German press has made repeated reference to what Handelsblatt has called “Germany's dangerous Chinese addiction”.

Either way, the market may be losing what faith it had in the ECB’s ability to bring inflation to target.

The ECB’s favored gauge of inflation expectations – the 5-year/5-year inflation-linked swap - began falling sharply in November and since the middle of December in particular. It now stands at 1.54% compared with an average and relatively stable 1.7% through 2018.

All in all, therefore, if Friday’s payrolls serve to preclude any talk of easier Fed policy, eurozone-US yield spreads which have become increasingly supportive of EUR/USD in recent weeks are going to struggle to hold on to current levels.