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ECB: eyes on the Euro

 

 

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Draghi was quite tough in highlighting that targeting a weak FX is in breach of international commitments.

 

 

 

 

 

 

While it is premature to say that there are generalized inflationary pressures in Europe, we expect a higher inflation rate in the coming months.

 

 

 

 

 

The EUR/USD is on a very strong upward momentum and seems very likely that it could continue to trade firmly in the 1.25-1.30 range.

 

 

 

 

 

 

Without major surprise, opportunities will stay with premium assets, peripherals, credit (from IG to HY) or convertibles bonds.

 

 

 

 

There is no real concern for the credit market at this stage. The gravy is indeed in the high yielding securities within the balance sheet, as overall credit quality is improving.

 

 

 

KEY INSIGHTS:

  • ECB FX concerns: This was supposed to be a “wait and see” meeting, but developments in the FX market, and the generalized USD weakness, led the ECB to express its concerns on the FX volatility. Draghi condemned possible currency manipulation as being in breach of international commitments, and highlighted that volatility in the exchange rate is a source of risks and it is certainly globally negative.
  • Market reaction: Markets reacted to the press conference initially by buying EUR, especially on the back of Draghi mentioning that “data confirm robust pace of economic growth”, that this strong “momentum boosts confidence in inflation pick-up”.EUR/USD is on a very strong upward momentum and it seems very likely that it could continue to trade firmly in the 1.25-1.30 range. We expect that the communication around currencies will remain very fluid in the coming weeks
  • Fixed income investing: The main risk in the market lies in this misleading inertia, inducing belief that the action of Central Banks really has anesthetized the markets. As inflation perception will probably be the main reason for the European Central Bank to change the path of normalization, opportunities will arise from Inflation Linked Bonds and duration play. Without major surprises, opportunities will stay with premium assets, peripherals, credit (from IG to HY) or convertibles bonds.

What are the main messages coming from the ECB meeting? 

Andrea BRASILI: Without the recent developments in FX, this could have been a quiet meeting. But it is clear that after the huge movement in the USD, the ECB had to express its concerns on FX and a lot of questions in the Q&A were related to the FX movements. Draghi was quite tough in highlighting that targeting a weak FX is in breach of what was agreed at the IMF meeting in Washington, explicitly referring to the US Treasury Secretary Mnuchin’s comments. He added that volatility in the exchange rate is a source of risks and it is certainly globally negative. It is also, obviously, a direct source of risk for the current monetary policy strategy. He then reiterated that, since October, the assessment of the economy is stronger, hence the Council is even more confident that the inflation objective will be reached. Nonetheless, there are still very scant signs of price pressures developing; hence the current accommodation must be maintained. In this picture, risks are balanced, with the possibility of positive surprises on the domestic (growth) side, and negative ones coming from external factors, including the FX; he also added that several members of the Council were concerned by these verbal intervention on FX. He then added some dovish comments saying explicitly three things: 1) The sequencing is in no doubt, no one in the Council is debating this; 2) He clearly favours a sort of smooth tapering after the end of QE and this will be discussed; 3) He sees very small chances for rates to go up in the current year.

What will likely happen in the coming months?

Andrea BRASILIThe March meeting (the 8th), with the release of the new forecasts from the ECB staff, will be key to define the next steps for the ECB monetary policy. But also the evolution of the international debate on the issue raised forcefully by Draghi, and the consequences on FX will be relevant. Despite the decline of the currency’s pass-through effects on the economy, it is useful to restate that in the September projections the ECB staff stated that a (gradual) 11% appreciation vs the USD (to 1.31 in 2019) translating in a 6% appreciation trade weighted, could imply a GDP that is 0.3% lower and an inflation rate 0.4-0.5% lower. As a final note, Draghi also added that, with regard to fiscal policy, it should be the right time to rebuild fiscal buffers, thanks to the very positive cycle. Hence, it is fine to implement growth-friendly fiscal policy, but not to pursue outright fiscal expansions.

An update on the output gap: are inflation pressures building up in the Euro area?

Andrea BRASILI: The ECB’s staff economists repeatedly stated in their works that it is difficult to evaluate and estimate the concept of the ‘output gap’ which has recently became even more elusive. But, even without a precise quantification, there is no doubt that the stock of underutilized resources in the Euro area has declined substantially. However, this is not yet enough to experience a generalized increase in wages and in prices. It must be said that the conditions on this issue are not that homogeneous and it is a good thing: inflation is a tad higher in Germany (HICP in December was at 1.6% YoY vs Eurozone average at 1.4% while it was at 1.0% in Italy and at 1.2% in France and Spain). Similarly, wages development seems a bit more dynamic in Germany (labour costs rose 2.2% YoY in Q3 in Germany vs 1.6% in Eurozone average, 0.5% in Italy and 0.1% in Spain). This is in line with the notion that Italy, Spain, and also France, still have to recover in terms of competitiveness vs. Germany, and that a situation in which prices and wages increase more in Germany than in the Euro area is beneficial. Hence, while it is premature to say that there are generalized inflationary pressures in Europe, we expect a gradual tendency towards a higher inflation rate in the coming months. If the USD weakness allows it.

Do you expect the Euro to continue the recent upward trend?  

Silvia DI SILVIO: The EUR/USD is on a very strong upward momentum and seems very likely that it could continue to trade firmly in the 1.25-1.30 range, especially if further broad-based US dollar weakness were to continue. The most important question addressed by Draghi was whether the recent appreciation of EUR vs USD was to be considered mostly endogenous, therefore justified and driven by better fundamentals. He gave a very direct answer by saying that the EUR has partially appreciated on the back of endogenous factors (“strengthening of the economy to some extent stronger than expected”) but also by comments made by “someone else”, clearly and undoubtedly hinting at the very recent remarks by Mnuchin on the USD weakness in Davos. In explaining why the EUR has risen so much recently he also added that there is “heightened market sensitivity in perceiving the change in the communication”. We expect that the communication around currencies will remain very fluid in the coming weeks (as also highlighted by Trump message from Davos supporting a strong dollar).

How will the evolving ECB monetary policy affect the European fixed income market? Where do you see risks and opportunities?

Eric BRARD: The ECB has already amended some of the components of its monetary policy over the last 12 months: Asset Purchase Programmes have been reduced twice, with official and unofficial communication being adjusted to prepare investors from all boards to the next monetary policy inflexion. Concurrently, yields for German Bunds have seen little change, spread for peripherals countries are tightening drastically (-30bps for Italy 10 Y, -220bps for 10Y Portugal) and credit spreads trending the same way. One could thus argue that the effect of the evolving ECB monetary policy could be negligible when it comes to Fixed Income markets. Conceivably, the main risk lies in this misleading inertia, inducing belief that the action of Central Banks really has anesthetized the markets. As inflation perception will probably be the main reason for the European Central Bank to change the path of normalization, opportunities will arise from Inflation Linked Bonds and duration play. Without surprise to the common investor, opportunities will stay with premium assets, peripherals, credit (from IG to HY) or convertibles bonds.

What drive the credit market in the next few months? Do you still see opportunities there and, if so, in which areas?

Eric BRARDOver the last 18 months, our strong conviction on credit has been confirmed by reassuring company fundamentals: there is no real concern for the credit market at this stage and in the forthcoming months. In reference to leverage or refinancing needs, same stance should apply. Main risks could be debt financed M&A, share buy backs, which could weaken balance sheets but this is probably not an immediate threat. In the conventional framework of “less active” Central Banks, companies have “front run” this move by issuing in advance and extending their debt profile. Thus, opportunities could be spotted in almost every sector of the credit space. Nevertheless, and as has been the case in recent years, our preference goes to Financials (positively impacted by broad economic recovery, steeper rate curves, more stable regulatory environment among others) and to their subordinated debt. The gravy is indeed in the high yielding securities within the balance sheet, as overall credit quality is improving.

 

With the contribution of:
Silvia DI SILVIO,
Fixed Income and FX Strategist

 

 

BRASILI Andrea , Senior Economist
BRARD Eric , Head of Fixed Income
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ECB: eyes on the Euro
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