The ECB: No need to rush

A year of potential political risks in the euro area saw the first key event – the Dutch general election on 15 March – pass without a shock. Voters in the Netherlands resisted the tide of populism with the establishment Liberals (VVD) of Prime Minister Mark Rutte taking the largest share of the vote and now seemingly heading back to government. Geert Wilders’ anti-immigration and anti-EU PVV party made only limited gains. And so, while talks to form a new coalition will likely take months to conclude, the EU-centred political stability that we have come to expect from the Netherlands is set to remain in place.

Of course, the focus of investors now turns to France, where the first round of the Presidential election will be held on 23rd April. And don’t draw too many conclusions from the Dutch vote. The electoral system in the Netherlands meant that Wilders was never going to take power. And the grievances of a large swathe of Europe’s electorate haven’t evaporated overnight with the passing of the Dutch election.

Indeed, France’s economic, social and security challenges are far more acute than those of the Netherlands. For example, the French unemployment rate of 10% is almost twice the Dutch level while the youth unemployment rate of more than 23% is more than double that in the Netherlands. And faith in globalisation, European institutions and the establishment in France is commensurately weaker. According to one recent survey, public confidence in the future of the EU among French voters is lower even than among the British.

So, it’s no surprise that the eurosceptic nationalist Marine Le Pen appears to be heading to win a place in France’s second-round Presidential run-off on 7th May. Among her few policies Le Pen wants to reintroduce the franc, a policy which would risk the mother of all financial crises in the euro area. Perhaps reassuringly, even in the unlikely event that she should ultimately win the Presidency there would remain significant constitutional obstacles to surmount before France could possibly ditch the euro. Moreover, for all the single currency’s flaws, a large majority of French voters supports continued membership. For this and countless other reasons, surveys suggest Le Pen will be beaten by whichever pro-European candidate she faces in the second round, if indeed she even makes it through to the second round.

Following last week’s first televised debate, and publication of further allegations against the right-wing Republican Fillon, the centrist former Economy Minister Emmanuel Macron is now clearly the favourite among bookmakers to become the next French President, with opinion polls currently giving him more than 60% of the vote in the second round should he qualify and face Le Pen. A lead of 25ppt or more is well outside normal margins of error, so – despite the precedents of Brexit and Trump – the probability that Le Pen will triumph now appears significantly less than 20%. And, if it is repeated in France, the high election turnout seen in the Netherlands, which clearly benefited the country’s pro-European parties, would similarly ensure a clear rejection of the populist candidate and her destructive policies.  

Defeat for Le Pen could only reduce rather than eliminate the populist threat. After all, her Front National party would still expect to make gains in June’s National Assembly election as a step to establishing a platform for future challenges. And she or a sidekick would expect to fight for the Presidency in five years’ time when no one can know what state France, the euro area and EU will be in. But it would certainly offer significant relief for investors in French government bonds, who saw spreads over equivalent German securities rise to multi-year highs over recent weeks on the back of pre-election nerves. It would also likely give a boost to more generalised euro area risk appetite. And it would remove probably the most significant downside risk to Europe’s economic outlook this year.

Indeed, assuming that French political risks don’t crystallise, the euro area economic outlook is now the most favourable for several years. Surveys suggest that economic sentiment is the strongest since before the euro crisis, while confidence in services and construction is the highest since before the collapse of Lehman Brothers. Manufacturers are citing the most plentiful order books for several years. And households are feeling more comfortable thanks not least to the near-five million net new jobs created over the past three years. Surveys such as the March flash PMIs also imply that economic output accelerated in the first quarter of the year following growth of 0.4%Q/Q in Q3 and Q4 of 2016. And when its Governing Council met earlier this month, the ECB upgraded its forecasts, with GDP expected to rise 1.8%Y/Y and 1.7%Y/Y in 2017 and 2018 respectively, and the downside risks considered to have become less pronounced. Our own growth forecasts are just the slightest fraction softer for each year.  

But inflation, not growth, is the main preoccupation of the ECB. Strikingly, euro area CPI rose to 2%Y/Y in February, above target for the first time in four years. And as that increase had taken it by surprise, the ECB upped its forecast for inflation in 2017, by 0.4ppt to 1.7%Y/Y. That, however, still means policymakers expect inflation to fall back somewhat over the course of this year – indeed, we share that view and think that the February reading will represent the high watermark for inflation this year. And the ECB also expects CPI to be a touch weaker on average next year, at 1.6%Y/Y, and still below target in 2019. 

The ECB’s lack of confidence in the inflation outlook is understandable not least since the recent jump has been caused by higher energy and food prices. With core CPI still just 0.9%Y/Y in February – no higher than the average of the past four years – the ECB admits there are no signs yet of a convincing upward trend in underlying inflation, which would require a significant change in behaviour of the labour market. Indeed, given the recent trend in labour costs, it is likely to be several months before the desired upwards shift in core inflation might possibly be identified.

Given the underwhelming inflation outlook, earlier this month the ECB made no change to its interest rates or asset purchase programme. Nor did it make any material change to its guidance on future policy, reiterating its willingness to increase QE or cut rates in future if required. But in his post-meeting press conference, Mario Draghi downplayed the likelihood of such action. And, assuming that the French election passes without shock, this explicit readiness to ease policy further seems likely to be retracted in June.

Indeed, Draghi did not dispel speculation that – contrary to what the ECB has repeatedly stated – it might even hike interest rates before ending its asset purchase programme. A couple of other members of the Governing Council also subsequently suggested that such a scenario might be desirable. And partly as a result, the market-implied probability of an ECB rate hike before year-end has now risen to about 50%.

Given still-subdued underlying inflation, a rate hike this year still looks premature. And the next material change to policy seems more likely to be a slowing in the pace of asset purchases from January 2018. But a first increase in the ECB’s deposit rate, currently a punitive -0.40%, might well follow shortly thereafter. And that step, which could be presented as the removal of an exceptional, but now arguably unnecessary, measure that helped successfully to ward off the risks of deflation, would be welcomed by banks as a step towards supporting profitability, and by other financial institutions who have long complained of the adverse effect of ultra-low bond yields on investment returns. More substantive moves towards normalisation of interest rates and an end to QE, however, seem unlikely to occur before the second half of 2018. We now expect an end to QE in Q318, with a first hike in the refi rate this cycle to come in the following quarter.  

*This article was originally written for and published in Japanese by NNA Europe (          


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