Economics and Strategy

European Outlook – In a Post-QE World, ECB Stumbles Out of the Starting Block; Brexit Deadline Extended, Every Option Remains in Play; Focus on EU Elections

— David Owen, Chief European Financial Economist
— Marchel Alexandrovich, European Financial Economist

It didn’t take long for the ECB to remind the markets that the end of QE didn’t mean the end of accommodative policy. The decision at the March meeting to amend interest rate guidance and offer new Targeted longer-term refinancing operations (TLTROs) came earlier than expected, with the ECB seemingly pivoting toward a ‘lower-for-longer’ stance. The generosity of the new TLTROs, however, remains unclear and the details will be key in terms of the overall take-up of new bank loans. One thing to keep in mind is that if the new TLTROs are offered at rates which are higher than the ones available in 2016, there could be an argument that the deposit rate may also need to rise, and perhaps the ECB will have to revisit the idea of a tiered deposit rate system.

With regards to QE reinvestments, as expected, the amendments to the ECB Capital Key weights, coupled with historic underbuying and overbuying of bonds means that some national central banks (NCBs) continue to add to their holdings of sovereign debt, while other NCBs are not fully reinvesting the cash generated through bond redemptions and will see their balance sheets contract this year.

The data flow to start the year has been mixed, with indicators of manufacturing output and global trade soft, but measures of services activity holding up well. Overall, growth in Q1 should see some improvement on last year; nonetheless, the performance of the euro area economy had disappointed expectations over the past year. This was reflected in the ECB’s latest quarterly forecasts, which saw the largest downward revision to GDP estimates since 2012. Digging into the detail, the ECB expects growth to return to trend in the second half of the year, a view that we very much with agree with. 2019 and 2020 will be years of growing imbalances and an increasing focus of attention for the ECB.

Similarly, in terms of inflationary pressures, the ECB is confronted with mixed signals. On the one hand, the labor market has been a source of strength with wage growth accelerating over the past year, and the Phillips curve seemingly starting to reassert itself. However, stronger wages are yet to translate to higher services inflation, although measures such as ‘super core’ inflation and the Jefferies Deflation Monitor analysis highlight some improvement in the data. Over the coming months, however, the late timing of Easter this year compared to last will play havoc with the core inflation prints, as the annual rate potentially falls very sharply in March, before rising back up in April, and then dipping again in May. The ECB should be content to sit on its hands until the summer. However, as the composition of the ECB’s Executive Board starts to evolve, so potentially could the markets view of where policy heads in 2020.

Whatever political challenges are likely to face the rest of the EU over the summer, it’s difficult to imagine anything will come close to the gridlock in the UK Parliament surrounding Brexit. At the time of writing, members of Parliament are attempting to take control of the process and indicate their preference for what Brexit should look like. The final destination is yet unclear, but the delay in the proceedings likely means the UK staying in the EU at least through much of this year, and the UK taking part in EU elections. Brexit is the Great Disruptor. The complicated ecosystem that has built up in recent decades has already started to unravel. FULL REPORT