Draghi Caught Between Chasing Inflation, Checking Hawks in 2017
(Bloomberg) -- Investor skepticism on the ECB meeting its inflation target may grow in 2017, with the limitations of the central bank’s monetary stimulus exposed as Draghi remains hostage to legal, fiscal and global factors, Bloomberg strategist Tanvir Sandhu writes.
- ECB’s efforts to bring inflation close to 2% “without undue delay” are curbed by judicial hurdles to QE tweaks, euro- area fiscal inaction, German inflation acting as a cap on peripheral price pressures and disinflationary effects of global factors such as yuan depreciation
NO SUSTAINED INFLATION
- With the euro area experiencing no sustained wage- and demand-driven inflation, risks are for entrenched low price pressures with core HICP unchanged from where it was in 2014 before QE started
- While EUR inflation 0% floor options have unwound the deflation premium, any sustained convergence of inflation toward the ECB’s target is far from priced in; EUR inflation 3y 1.5% cap is at 30bp, not far from record lows; chart here
- ECB’s own 1.7% inflation forecast for 2019 is casting doubts on the goal of reaching 2% without undue delay; that may weigh on inflation forwards with disinflation risks emerging from yuan depreciation
- Still, Draghi reduced asset purchases to EU60b per month to satisfy hawks in the governing council amid the fading of the deflation distribution, but increased the stock and widened the pool of eligible bonds given the need for a sustained presence in the market
- ECB targets look far out of sight with German core inflation, currently at 1%, unlikely to reach close to 2% anytime soon and as peripheral countries may need core inflation to remain below northern euro-area in order to protect competitiveness; chart here
REPO DISTORTION
- German repo scarcity still remains a problem even after the ECB allowed the use of cash as collateral, given the 70bp capped cost, size vs pool of assets investors would borrow and that Bundesbank is required to address other lending facilities terms; see more here
- Click here for chart showing the recent widening of Schatz-Eonia and Depo-GC spreads
- While German curve faces steepening pressure with average maturity of ECB purchases set to drop after the depo yield floor removal and the inclusion of 1-year bonds, ultimately bund 10s30s may face flattening pressure from the richening in the front-end and disinflationary pressures
- Belly of the curve may outperform as QE buying below the ECB depo rate will likely start there and with potential for hike in Eonia forwards to be pushed out
QE CONSTRAINTS
- Draghi has cited “an increasing awareness of legal and institutional constraints” on increasing the issuer limit on QE purchases from 33 percent; any move toward additional QE tweaks could worsen concerns about contravening the Maastricht Treaty’s prohibition of monetary financing
- Such legal obstacles to raising the issuer limit on non-CAC bonds in QE doesn’t benefit German long-end bonds
- Portugal is the biggest loser here given small pool of bonds vs its capital key, as it nears issuer limit of 33% given SMP holdings; Draghi didn’t mention using flexibility within the capital key
- Political and financial uncertainty in Italy, upcoming Dutch and French elections and new issuance at the start of the year may see investors fade any spells of tightening
- Widening pressure on peripheral bond spreads may increase in second half of 2017 to price further QE tapering risks in 2018
- NOTE: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.
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