The recovery seems to be on track and broadening. Last week’s final PMI figures for the manufacturing sector was above the 50-mark – which separates expansion from contraction – in six countries including Italy, Spain and Ireland, and only below the 50-mark in France and Greece. The Greek PMI was even at a 52-month high and very close to 50. On the other hand, credit growth continued to drop and the too strong EUR and rising rates are clear risk to the recovery going forward. It will not take much new key figure weakness to prompt another refi rate cut, in our view, but it will take some.
Inflation is probably close to the bottom. After a very low reading in October, inflation has crawled up a bit, and this week’s flash December reading is likely to come out at 0.9%, which should be enough to keep the ECB content for now. In the same Spiegel interview as mentioned earlier, Mr Draghi said: “we must be very careful that we do not permanently fall below 1% inflation and thus into the danger zone.” Thus, inflation is too low and the ECB will react again if inflation falls further or if medium- to longer-term inflation expectations start falling. However, if will take new weakness to prompt new action. Indeed, the pressure from long term inflation expectations has subsided markedly over the past month. The 5Y5Y inflation swap now lies at 2.22-2.23%, almost 10bp higher than late November, and is thus at a level more compatible with the traditional assessment of inflation being “firmly anchored”.
Liquidity conditions are normalising. Following a long period of banks repaying LTROs to the ECB and excess liquidity dropping very fast ahead of the date of balance-sheet snapshot for the Asset Quality Review, we now believe banks can take on more liquidity from the ECB again. Excess liquidity increased significantly after the turn of the year and front-end money market rates should gradually come down again and take a bit of pressure off the EUR as well. Short market rates have normalised quite a bit already. The 3M Euribor fixing is down 2bp since late December, short Eonia swaps down 5-7bp and the EURUSD xCcy basis spread is down 5bp to -4.25bps.
Still, we believe monetary conditions could be one of the ECB’s main concerns to address at this first meeting of the New Year. However, again, it will take a strong EUR or continuously rising rates or tight liquidity conditions to make the ECB act again.
We expect this week’s meeting to be fairly neutral to the markets
We believe Mr Draghi will point to the achievements of monetary policy in restoring confidence and safe-guarding the confidence that is needed for a sustainable recovery to materialise. However, given the worries and reliefs listed above, we expect the ECB to keep the doors open to all possible easing measures without promising any concrete new actions for now. This seems to be in line with market thinking and should be fairly market neutral.
Nordea