ECB still a big, fat dove

Nordea with the note:

There was broad support for the ECB to increase the pace of its bond purchases, but that support may wane, as the economic situation improves. We continue to see moderately higher Euro-area bond yields ahead.

The monetary policy account from the ECB’s March meeting indicated that there were no strong objections to the central bank’s decision to increase the pace of its bond purchases, though there was more discussion on how much the pace should be increased. In this context, it was argued that a more moderate increase in the pace would better reflect the assessment of more balanced risks to the outlook, also in the light of previous decisions when a similar pace had been chosen but economic conditions had been worse.

While broader financing conditions had remained easy, the increase in longer nominal yields was seen to be driven by increasing term premia and spillovers from US bond yield increases on the back of the expected US fiscal stimulus, as well as rising commodity prices and improved growth prospects globally, which was not supported by the Euro-area outlook. It was further noted that the optimism prevailing in financial markets was not shared by businesses and households.

Risks to the outlook continued to be tilted to the downside, but mostly in the short term, while the risks were more balanced for the medium-term outlook. Further, while the pandemic continued to imply downside risks, the balance of risk was now shifting and becoming more balanced, or possibly even starting to shift to the upside. The most recent US fiscal stimulus was not factored in the ECB’s March forecasts, and was seen as a clear upside risk for both growth and inflation forecasts. It was also noted that real GDP growth had been repeatedly underestimated in successive quarters over the past year, and household consumption could surprise to the upside.

We do not expect the ECB to expand the PEPP envelope further, but do see net asset purchases continuing beyond March 2022, the currently communicated minimum duration of the PEPP, as the Euro-area inflation outlook continues to look muted. We do expect the weekly purchase volumes to fall again later this year, as the economic recovery materializes.

On this note, it was emphasized that all members joined a broad consensus around the proposal put forward by Mr Lane, on the understanding that the total PEPP envelope was not being called into question in the current conditions and that the pace of purchases could be reduced in the future.

The ECB will revisit the pace of the bond purchases again in June, unless a pressing need arises to make changes earlier. We see more room for gradually higher Euro-area bond yields also going forward, driven by higher US yields and an improving Euro-area economic situation. The significantly higher pace of bond purchases, which appears to mean net PEPP purchases of around EUR 20bn a week, is unlikely to be enough to prevent yields from rising at all, while the ECB seems unwilling to increase the pace further, unless yields rise rapidly and materially.

ECB managed to stop the increase in longer rates for now

Higher US yields to increase upside pressure on German yields as well

Further key parts from the monetary policy account

  • Recent yield increases had instead reflected, by and large, rising term premia. As the increase in term premia coincided with a notable rise in inflation swap rates, it was likely that the inflation risk premium had become larger as investors had started reappraising the balance of risk around the inflation outlook. An increase in the inflation risk premium at the current juncture suggested that investors no longer only saw downside risks around the future inflation outlook as they had done for most of 2020.
  • The slowdown in the growth of lending reflected firms’ substantial liquidity buffers but also the continued postponement of fixed investment and a perceived tightening of credit standards.
  • Sizeable and persistent shifts in market interest rates, if left unchecked, were likely to withdraw monetary stimulus prematurely at a time when preserving favourable financing conditions remained necessary to underpin economic activity and safeguard medium-term price stability.
  • Attention was drawn to the fact that the additional US fiscal stimulus package (part of the Biden Administration’s American Rescue Plan – the so-called “Biden plan”) had not been factored into the March 2021 ECB staff projections, as the stimulus package had not been passed into legislation at the time the projections were finalised. This was seen to constitute an upside risk to the global and, consequently, euro area economic outlook as embedded in the staff projections.
  • On the one hand, it was stressed that real GDP growth had been repeatedly underestimated in successive quarters over the past year, pointing to the economy being more resilient than expected. It was argued that, beyond the short term, there could be grounds for a more optimistic view than had been taken by ECB staff on the medium-term outlook if, for example, assumptions regarding the evolution of the saving ratio turned out to be too conservative.
  • Some concern was expressed that the true situation of the business and household sectors would only become apparent once the government support and guarantee schemes in response to the pandemic were phased out. This related, in particular, to the risk of insolvencies and their impact on bank balance sheets.
  • At the same time, it was stressed that euro area countries were rather heterogeneous and that debt vulnerabilities, which to some extent predated the pandemic, had been exacerbated. Hence, it was conceivable that the saving ratio would remain higher than before, reflecting heightened caution and future deleveraging needs.
  • In their assessment of the balance of risks, members re-emphasised the dichotomy between continued elevated risks to the outlook in the short term and more positive developments in the medium term.
  • It was observed that there had been a small upward surprise in the latest HICP data also after accounting for the temporary factors.
  • It was also reported that contacts with businesses pointed to a perception of higher inflation in a context of spikes in commodity prices, supply bottlenecks and rising production costs. This warranted a close monitoring of producer price developments going forward.
  • Although a better economic outlook in the United States also entailed positive demand effects for the euro area, it was observed that the optimism prevailing on financial markets, reflected in “reflation trades”, seemed not to be shared by businesses and households, which had generally maintained a cautious stance.
  • Financing conditions for the non-financial private sector had remained very favourable overall, also on account of ample monetary policy support.
  • A possible misperception that the Governing Council was engaging in a form of implicit yield curve control had to be avoided.
  • The view was also expressed that, as long as the medium-term inflation outlook remained unsatisfactory, the Governing Council needed to preserve financing conditions close to the favourable levels observed in December to bring inflation back to the projected pre-pandemic path. Any material tightening in financing conditions, irrespective of the underlying driver and origin, would delay the convergence of inflation to the Governing Council’s aim of below, but close to, 2% in the medium term.
  • Against this background, although the risks to the economic outlook for the euro area were becoming more balanced over the medium term, the recent tightening of financing conditions was generally seen as premature for the euro area, which was still in a weaker cyclical position than the United States.
  • There was broad consensus among members that the recent rises in risk-free rates and GDP-weighted sovereign yields required a scaling-up of the pace of purchases under the PEPP.
  • It was underlined that the flexibility embodied in the PEPP was symmetric, implying that the purchase pace could be increased and decreased according to market conditions.

Note the German versus US scale on the yield chart. Why anybody would want to own EUR defeats me.

That said, there is a risk here for DXY bull market thesis. It is this, via Goldman:

In a fresh Global Views, “Converging Higher,” Jan Hatzius highlights how growth in Europe is likely to accelerate similar to what we’re seeing in the US – once the region gets over the ongoing virus wave. Jari Stehn sounds a similarly positive tone in “Euro area: Rising Confidence in the Rebound.” Notably, daily new cases are now starting to decline, vaccine distribution is picking up, and business sentiment surveys are surprisingly encouraging. For the four quarters 2Q21 through 1Q22, we forecast Euro area GDP growth of 7.0%, similar to the 7.4% surge we are expecting over the same period in the US. And when the focus shifts to European-driven demand, the CEE-3 currencies and the Euro itself tend to outperform the most writes Michael Cahill in “Readying for a EuropeanRebound.”

I see this more as more a timing than fundamental issue. If the European rebound arrives as the US falls briefly off its fiscal cliff and before China slows, say, at the end of this year, then we could see a run higher in EUR and hit to DXY. The base case is that further into 2022, the next round of Biden stimulus adds another leg to US growth as Europe fades with China.  But there may be scope for a decent corrective rally in DXY in this mix.

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